Morningstar Star Rankings Fail Mutual Fund Investors

Mutual fund investors adore Morningstar. The Chicago firm publishes rankings for most of the funds that have lasted for three years or more. It awards anywhere from five stars (top rung) to one star (the cellar), based on past performance, minus sales loads and adjusted for risk.

Money pours into the four- and five-star funds. They're touted on fund-company websites as well as in print and online advertising. You read the boilerplate phrase -- "past performance is not a guarantee of future results" -- and interpret it optimistically. Maybe not a guarantee (you say to yourself) but a strong possibility (you're sure) of outsize gains.

Wrong. Morningstar's own research shows how little its stars are worth as investment guides, especially at market turns.

In placid years, the stars generally behave -- at least, in a limited sense. The average five-star fund does a little bit better than a four-star fund in its category, and so on down the line. The differences can be tiny. Four-star performance might top that of the three stars by 0.5 percentage points or less. Also, those are averages. Any individual fund, in either group, could do much better or much worse.

More importantly, five-star funds don't linger in the stratosphere. New investors are buying near the peak. Over the following three and five years, the funds' average performance will fall to the middle of the pack. The next time you look, you'll probably find that you now own a three-star fund. Other managers will have outperformed and risen to the top. The next generation of five-star funds could come from anywhere on the list.

If you grump, sell your fund, and buy the new leaders, they'll gradually fall to the middle, too.  Chasing performance is a loser's game.

In years of big market changes, even the basic star pattern doesn't hold. Performance analyzed in 2007 (the latest year available) turned some of the numbers of their heads. Among bond funds and balanced stock-and-bond funds, lowly one-star and two-star funds did far better in the following two years than the five-star glamour boys. For example, one-star munis chalked up an annual total return of 2.77 percent, compared with a loss of 0.98 percent among the five-stars. For this group, "the star ranking has subtracted value so far," says Russel Kinnel, Morningstar's director of mutual fund research.

Among all-stock funds -- both U.S. and international -- the 2007 five-stars still outperformed the one-stars but not by much. Their relative rankings turned out to be about the same. The star awards did neither harm nor good.

What can investors gather from all this? Five things.

• On average, one-star stock funds fall far enough behind the leaders that it pays to ignore them -- even though they have good years.
• On average, five-star funds will lose their steam. Tomorrow's big gainers will come from elsewhere in the pack. A three-star manager with five stars in his or her past might cycle back up, when those types of stocks get popular again.
• Each "star" group will have better and worse performers, and the stars can't tell you which ones they'll be.
• Low-cost funds in all categories get better star ratings than high-cost funds. That's probably because the expensive funds take on more investment risk. They need higher returns to cover their costs and still be competitive. Their strategy might be successful but it's also more likely to fail. That's what "risk" is all about.
• Of all the so-called predictors of future performance, low cost is the only one that consistently works.

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