Oh, how we all love ratings systems. With “Two Thumbs Up” and 100% ratings on RottenTomatoes we rate our movies. We look for five-star restaurants on Yelp and five-star hotels for our next vacation.
And we love them for mutual funds. Fund companies advertise their Morningstar-rated four-and-five star funds over glamorous images of speed skaters, pro cyclists and sailboats pulling away from the competition. But here’s the problem. Those speed skaters and cyclists and sailors, they have a verified skill. They are competing at the top levels of their sport after years of dedication and hard work. And year after year, there they are, at the top.
That five star fund manager? There’s no telling where he’ll be next year. Morningstar’s star rating system is entirely based on past performance. A manager who had a good run over a few years will see his star rating jump. Ultimately, we’re awarding star ratings to which manager was the luckiest.
It is well documented that it is nearly impossible to distinguish skill from luck in investment performance, and there is no consistency of investment performance among those “top” managers.
This means that the fund that was in the top of its category or peer group last year has no better chance of being there a few years later than anyone else. In fact, in most categories, the consistency of performance was worse than a random outcome would expect.
Morningstar themselves admit that star ratings are not intended to be used to predict future results. My favorite disclaimer in the industry is “Past Performance is no Guarantee of Future Results.” We’re forced to say this because it is true.
And yet, investors and their advisors keep going back to the star-rating trough, looking for a winner. Clients of financial advisors want to know why funds they own aren’t five-star rated, and advisors pitch their clients on new ideas by touting the star rating and “great long-term track record.”
Please, please resist the allure of the star rating. It does us no good to identify which fund did the best in the past. The success of an actively managed mutual fund is as consistent as a flip of the coin (worse, in fact, after considering expenses). It doesn’t matter if your fund has three stars or five stars. What matters is that you keep your investment expenses low, manage the tax consequences of your investment decisions and remain dedicated to a consistent long-term investment policy.