Should you invest in mutual funds based on the Morningstar 5-star rating? The answer is an unequivocal yes…but not for the reasons you might think.
Are 5 Star Funds Actually Better?
Fund companies have been touting their Morningstar 5-star rated funds for years. Just look at this ad from USAA.
Here is one from T Rowe Price. “Over 70 of our funds have earned 4- or 5-star Overall Morningstar Ratings as of 11/30/17.”
Many firms tout their five star funds in similar fashion.
The implication of course is that 5 star fund ratings are better funds, better than those with lower star ratings, and worth your investment dollars.
This USAA ad specifically states: The following USAA mutual funds have earned four or five stars from Morningstar based on their performance.”
The irony is that every single prospectus out there states something like, “past performance is not indicative of future results.” In fact, from USAA’s own summary prospectus:
Remember, historical performance (before and after taxes) does not necessarily indicate what will happen in the future.
You don’t even need to go to a T Rowe Price fund prospectus to read “Past performance cannot guarantee future results”.
You’d be hard pressed to find a better example of talking out of both sides of your mouth than the investment industry.
What’s an Investor to do When Choosing Funds?
Thankfully, Morningstar itself did an analysis of FUTURE performance of its previously named 5-star funds. See document here.
To its great credit, Morningstar has never hyped itself as a predictor of mutual fund performance. They have always stated, explicitly for those who care to read it, that their fund ratings are based on a number of evaluation criteria but “we haven’t promoted the star ratings as an infallible predictor of future success.”
That Morningstar provides just an endless source of information about so many thousands of funds, and much of their data is free, is truly incredible. Their information has helped shine the light on fees, taxes, risk etc., which has forced the mutual fund industry to respond by bettering itself, for the most part.
Morningstar Analyzes Their Own Rating System
However, I was still a bit cautious as I began to read the Morningstar self-evaluation on how their previously 5-star rated funds did in terms of future performance. I mean, as much as I like Morningstar, are they REALLY going to give us the unbiased truth? After all, if their 5 star funds don’t do have better future results, well, what’s the point of using their research?
But as I have come to expect from Morningstar, they put their research out for ALL to see. Global Warming Alarmists take note!
Before I dive into the report let me just take a moment to thank Morningstar for their impeccable honor. They are truly a standout firm which have helped the average investor many times over. They are a force for good in the investment industry.
Only 10% of Funds Get 5 Stars
It’s important for investors to understand how Morningstar rates their funds. They use a 5 star system with 5 being the best and 1 being the worst. For the record, Morningstar would NEVER say a 5 star rated fund is the “best” and a 1 star rated fund is the “worst”. They’re too tactful for that kind of language. But I’m not that tactful.
Only 10% of funds get a 5 star rating. Whereas all the other rating classes have 22.5% each. Thus the 5-star rated funds are truly standouts for what Morningstar is basing their ratings.
Morningstar Adjusts For Survivorship Bias
Morningstar also takes survivorship bias into their research which is very important.
What happens in the investment world is many low performing funds actually close up shop and thus their poor performance doesn’t get factored in a lot of investment research.
If you’re a sports fan think about it like this. Say you have a league with 10 teams. They each play 16 games. Some teams go 12-4, others 3-13 and so on. In the end, the average win/loss record of the league as a whole is 8-8. 10 teams in the league + 16 games per team = 160 games played. In the aggregate the league record is 80 wins and 80 losses. (I get there were only 80 ACTUAL games played. Each game has 2 participants meaning there are two results per game, one win and one loss.)
Now, say a team that went 2-14 folded, they went broke because they couldn’t get enough paying people in the stands to watch a losing team play. There are now only 9 teams left. What’s the average record of the teams in the league now?
Well, given that now there are only 9 teams in the league, the survivors if you will, if we look at the aggregate record for the remaining teams it’s 78 wins and 66 losses. Meaning the average team in the league has a record of 9-7.
But how can that be??? How can there be MORE wins than losses when each game has one winner and one loser? That doesn’t make any sense. It’s literally an impossibility.
Factually it’s NOT impossible if you don’t factor in survivorship bias. If you were a prospective owner looking to spend money on buying a team, you’d ask about the ability for the league to sell tickets. You wouldn’t want to buy a team that can’t get people in the stands, after all.
The league owners, desperate to get you to invest in the league, would say “our average team has more wins than losses so, there’s a good chance you’ll have a winning record and be able to sell more tickets.”
Of course, what they are NOT saying is that they have not counted the record of the team that folded. That is survivorship bias. It completely skews the numbers in favor of those that have ‘survived’ by taking away the bad numbers for those who have gone extinct.
This kind of shoddy research has plagued the investment industry for decades because it allows funds that do nothing but survive look better than they truly are simply by still being around.
Here is Morningstar’s take on Survivor Bias:
Survivorship bias is created when poor-performing funds liquidate or are merged away. When these losing funds are omitted from category-average performance statistics, the averages tend to creep higher than they would be if the losers were still in the mix.(emphasis mine)
Morningstar Analyzes Risk-Adjusted Returns
Morningstar incorporates risk-adjusted returns when factoring in their analysis. This is also important. Remember back in the heyday of the late 1990s the investment world was dominated by risky funds. Great article here about the rise and fall of these fund managers.
These guys were making money hand over fist, but they were taking on enormous risks which ultimately lead to their downfall. Morningstar tries to deal with this by incorporating the risk into a funds returns, rather than just looking at the fund’s total returns.
A fund that is currently thriving may be doing so simply by having a string of good luck. Maybe the manager is riding a wave of technology stocks that are booming, like what happened in the late 90’s. Yet, if that technology sector gets hammered the fund most likely will too and will be faced with huge redemptions from investors. The more investors redeem shares, the greater the liklihood the fund will no longer be able to remain in business.
It’s the long-term investors who face the biggest fallout from a fund which is closing shop. If they bought the fund in the beginning and road it all the way up but also stayed on while it liquidated, those investors are going to be holding a wet bag of enormous tax consequences and probably investment losses as well.
Morningstar certainly doesn’t want to reward mutual funds that just get lucky, in the short term. So they make it a point to factor in risk when analyzing funds.
Morningstar Adjusts for Various Share Classes
Finally, there are just way too many mutual funds out there today. The same fund may have 5 or more different classes of fees, sales charges, etc. Morningstar adjusts for all of that, thankfully. There simply would be no way for an average human being to weigh through all the funds with all the varying classes of funds and come out with any sanity left.
Morningstar 5-Star Funds DO Outperform…But Not By Much
Morningstar states the “star rating is the start of the selection process, not its conclusion. Just as a a university wouldn’t claim its A students will achieve greater success than its B or C students.”
But they did conduct this study to analyze “its ability to predict risk adjusted returns.” And they did find “the star rating had some moderate predictive power…”
How much predictive power though? Well it turns out, not that much.
“Our findings suggest that 5 star funds outperformed 1 star funds by approximately .25 percentage point annualized on average across multiple holding periods and market cycles.”
So, with all the noise surrounding 5-star funds, their ability to predict future out-performance comes down to ¼ of 1 percent!
In fact, they even go on to stay “(l)onger-term event study results further suggest that, on average, investors who bought higher-rated funds have tended to earn higher returns than those who have purchased lower-rated funds, though the magnitude of this outperformance is low.” (emphasis mine)
In fact, Morningstar says the small out-performance of higher rated funds is “likely caused by the star ratings high correlation to fees and that over time these differences accumulate in an economically significant way.”
Interestingly too, is that as the time period expands the outperformance of higher rated funds declines. So what causes the initial outperformance “bump”? ”Given that the star ratings are based on past performance we think that these findings are consistent with a “monmentumlike” interpretation of the star rating in the long run.”
What Morningstar seems to be saying here is that the outperformance of funds in the short term really has to do with that fund receiving their blessing and thus increased exposure generates a short term bump.
This would not be unlike a stock moved onto the S&P 500. Lots more demand for said stock when that happens, thus bumping its share price up, for reasons that have nothing to do with fundamentals.
Now over a 60 month period, what I find very interesting, is that 4 star equity funds actually outperformed 5 star funds. Not really surprising when you figure that only 10% of funds receive a 5 star rating. So it only takes a couple to lose steam before the entire 5 star universe begins to lose traction against the much larger 4 star population. A couple of losers in a smaller crowd will definitely effect that crowd more in the total than a couple of losers in a bigger crowd. Diversification rears is beautiful head once again!
There WAS a significant difference in the star ratings for predictive performance on bond funds though. I was actually surprised the Morningstar report didn’t focus on this more. The 5 star funds had a 10% higher performance than the 1 star funds.
I believe this out-performance for the bond funds can be attributed solely to fees. Morningstar doesn’t state that explicitly but if you read enough data on bonds and bond funds there really is no other reason for that out-performance to exist.
So, at the end of the day, what’s the end result of Morningstar’s rating system? Well, I’ll let them speak for themselves:
“the returns of 5 and 4 star rating portfolios have been higher than those of the other star rating cohorts, but not substantially so.”
Here’s Why You SHOULD Use Morningstar Ratings
Morningstar is just one of many, basically all, research groups show that fees correlate with returns. There really is no debate on this topic anymore. You’d have a much more interesting debate discussing the pros and cons of vaccinations than one focusing on the expenses of mutual funds verses long-term performance.
Here’s a quick article from two titans of the investment research world, French/Fama. “The high management fees and expenses of active funds lower their returns.“
This article actually takes issue with a Wall St. Journal criticism of the Morningstar fund rankings and ends by saying:
As I have written previously, the single most reliable guide to selecting actively managed funds that will generate risk-adjusted outperformance is low costs.
Morningstar itself has a great report on the same topic here: The expense ratio is the most proven predictor of future fund returns.
In terms of survivor bias, they note “5 star funds were also more likely to survive a full event-study horizon than lower rated funds.”
I can’t stress this enough. So many funds boom for a year or two and then later are gone, discarded to the dustbin of history never heard from again. Real life investors suffer from this. They lose their money and many are going to even have to pay taxes on money they lost! Yes, you heard that right, only in the mutual fund world can you pay taxes when you lose money.
Lastly, while the ratings don’t provide a HUGE bump in future performance, there is some! .25% is STILL .25% after all, and with bond funds it is MUCH larger than that.
Think about it like this. Say you have a fund that returns 5.75% and I have a fund that returns 6%. My fund outperformed yours by .25%. Doesn’t seem like much right?
Well, if we each put $100k into our funds, over 10 years I’d have $179,000 and you would have $174,000. Not a huge difference, I understand, but could you use an extra $5k? I certainly could.
A .25% difference in performance ultimately means I am getting 5% better returns than you, year in, year out.
Why I Like Morningstar’s Highly-Rated Funds
Morningstar “rewards longer term performance, low volatility of returns and low fees.“ So, while you may not truly outperform by much in using the Morningstar funds rating system, you will most likely have a smoother, less expensive ride in getting to your end destination, with possibly a small amount of out-performance as well.
And if that’s all that the Morningstar rankings can help with, well, that’s just fine by me and for you too. [sa_captivate]