Investors seeking the best buy among mutual funds should be cautious about how they use the Morningstar rating system in selecting their purchases, according to a Fordham University study. Many investors look to Morningstar, one of the most widely used mutual fund rating services, to predict which funds would be the highest performers and best investments. Morningstar uses a five-star system to rate a fund’s performance, with one star being the worst and five, the best. “You would be misguided to use them if you were trying to pick funds that were going to have superior performance in the future,” said Associate Professor Christopher Blake, who teaches finance in the Schools of Business and co-authored the study. “Morningstar ratings should be viewed as achievement marks from past performance, not predictors of the future.”
Blake and Assistant Professor Matthew Morey of Pace University’s School of Business started researching domestic equity (stock) funds in 1998 to determine how well Morningstar did at predicting future fund performance. In almost all of its publications, Morningstar states that its star ratings are not predictors of future performance. However, many funds advertise their Morningstar ratings, and investors tend to pour their money into five-star funds, which they expect to be the most profitable. The professors’ study revealed that low ratings from Morningstar generally indicate relatively poor future performance.
But the same cannot be said for its future predictions of median- and high-performing funds. “Morningstar tends to predict the turkeys (one-star funds) well, but when it comes to predicting winners, there is little difference statistically between the subsequent performance of three-, four- and five-star funds,” Blake said. The study, titled “Morningstar Ratings and Mutual Funds,” appeared in the September edition of The Journal of Financial and Quantitative Analysis (JFQA), a top-tier finance journal. Blake and Morey studied the performance of more than 600 mutual funds rated by Morningstar over a five-year period.
They studied five different types of domestic equity funds including aggressive growth, equity income, growth, growth income and small-company funds. The professors also divided the funds based on age and examined subsequent performance over 1-year, 3-year and 5-year investment periods. The study found that many funds have a chance of doing as well or better than a fund picked for a five-star rating, Blake said. “The star ratings are useful for telling you which funds to avoid (one-star and two-star funds), but when it comes to picking future winners, you need to look beyond the stars,” he said.