May 28, 2010

Five-star mutual funds don't live up to their past

Tim Courtney decided he'd had enough. In meeting after meeting earlier this year, he and his colleagues at Burns Advisory Group had recommended mutual funds to prospective clients, only to be hit with the same response almost every time: Why are you telling me to invest in a three-star rated fund?

That sums up the way many investors allocate money to funds -- look at products that have four- or five-star ratings from investment researcher Morningstar Inc., take that as a seal of quality, and hope for the best. Such decisions are perhaps even more common in volatile markets, when anxious investors view top-ranked funds as somehow better-equipped to handle adversity.

The trouble is that investors seem to forget that star ratings are backward-looking, based on a fund's past performance, and studies have shown the ratings have no predictive value.

"Having to get over that hurdle [of explaining that star-ratings shouldn't influence choices], every time we recommended a fund that wasn't five-star, is something we have to do time and time again," said Courtney, chief investment officer of Burns Advisory, which manages about $300 million and advises about $150 million of 401(k) assets.

So Courtney and his colleagues went back to Dec. 31, 1999 and studied the subsequent 10-year performance of five-star rated funds. What he found might convince investors to kick their star-rating habit.

Of the 248 stock funds with five-star ratings at the start of the period, just four still kept that rank after 10 years. And the 218 domestic stock funds with the rating typically lagged their category averages over the period -- not just the benchmarks, but other mutual funds. The exceptions were 30 foreign large-cap funds, which had a 10-year annualized return of 1.44% compared to their category average of 1.32%.

In other words, it's not just that five-star funds don't, on average, continue to lead their peers -- they actually do worse in subsequent years.
The worst performers were small-cap growth funds. The category's 29 five-star funds in 1999 lost an average of 3.6% annualized over the next decade. The category overall was up 0.6% in the period.

Stars come out

But Courtney's findings will have to go a long way before investors lose their starry eyes. Four- and five-star rated funds captured about 72% of the roughly $2 trillion of net inflows into all funds with star ratings over the decade through Dec. 31, 2009, according to Morningstar. Thirty percent went into three-star funds, while less than 1% went to two-star funds. The numbers add up to more than 100% because of net outflows from one-star funds.

There are valid reasons for inflows numbers, for instance the fact that some extremely good funds are four- and five-star rated. But the figures also suggest a strong element of performance-chasing -- returns that by definition are in the past and may not be repeated.

Courtney said that rather than performance, what he looks for in a fund is relatively low cost and low turnover, with investment strategies he understands and which the manager doesn't frequently change.

He added that he prefers diversified, rather than concentrated, portfolio holdings. And while he doesn't discount performance completely, he takes issue with the myopic focus investors place on past results.

"Investors use the star ratings to the exclusion of other data," he said. "It's very frustrating."

Source: MarketWatch

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