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Be Careful When Reviewing Mutual Fund Ratings

 Wherever you look, you will find various rating systems for mutual funds, each using a different approach. They are all designed to find the best of the best among thousands of funds. But is there really such a thing? Does a high rating really mean that a fund will perform better in the future? Many people seem to think so. A recent study showed that Morningstar, North America’s most recognized rating system for funds, has a tremendous impact on fund sales. If Morningstar gives a five-star rating, sales of those funds generally increase.

While rating providers are careful to warn investors that their ratings do not predict the future, the star system is unfortunately used by some investors like reading Consumer Reports to buy a new drill. Supporters of the ranking approach argue that there is no subjective component to the star rating. It is not determined by an analyst’s review and cannot change because the service doesn’t like the fund’s manager or investment strategy. And that is a good thing.

Performance will vary. According to another recent study by Matthew Morey, a professor at Pace University, during the three years after a fund is given its first five-star Morningstar rating, fund performance generally declines and risk levels rise. One reason for this, according to Morey, is that fund size increases dramatically after receiving five stars, making the fund difficult to manage. Since Morey’s study was completed, Morningstar has also changed the way it assigns top rankings to make them more precise. One of the biggest problems with all rating systems is that they are inherently unpredictive. This means that they are not really set up to tell whether certain funds will outperform in the future. For the most part, the ratings show how much you might have gained and how much you might have suffered in the process.

Combining risk and return. For example, a five-star fund might have moderate return scores, but incredibly low risk scores. Another five-star fund might have much higher risk scores, but its return score might still be strong enough to help it rank in the top 10% of the group.

In some cases, in fact, it is not even the same fund to begin with. Remember, after a management change, the rating stays with the fund, not the portfolio manager. Therefore, a fund’s rating may be based almost entirely on the track record of a manager who is no longer with the fund.

Understand how ratings are developed. Too many people place importance on results without knowing how they were achieved. If you are going to use ratings, take the time to understand how they were developed and what they really mean. It is the journey that matters, not the destination.

Past performance is no guarantee of the future. You have probably heard this warning a thousand times before, but it is really important to understand. Most rating systems have little to no element of prediction. It is natural to assume that the person who has performed best in the past will perform best in the future. Unfortunately, it is not that simple. Think about it; if it were that easy, investors would keep buying last year’s winners knowing that they will be this year’s winners. And this rarely works.

Ratings are a crucial element when trying to distinguish between good and bad funds. But good research goes far beyond just looking for five stars or A+. When evaluating funds, look at the quantitative, measurable characteristics of a fund: returns relative to benchmark, costs, risks, taxes and manager tenure. Use rating systems as part of your research, but remember: just because analysts give them the highest ratings does not mean they will be the best investment in the future, and especially not the best investment for you. Take the time to understand how ratings are obtained. This will be the first step in educating yourself about funds.