

The Trouble With Star Ratings

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It's hard to turn a blind eye to a mutual fund's star rating from Morningstar, even if you know better. It's at the top of the Morningstar quote page, in bold print, and fund companies love to cite these ratings in their advertisements -- not to mention in their e-mails to journalists.

Yes, star ratings are a simple gauge of a fund's historic risk-adjusted return, but they can be misleading in a variety of ways. John A. Haslem, professor emeritus of finance at the University of Maryland's Robert H. Smith School of Business, recently culled various studies on Morningstar's fund selection measures for a paper published in the current issue of the Journal of Wealth Management. It's a good recap of why investors shouldn't give too much credence to any single yardstick of quality, particularly one based on past returns.

Morningstar, for its part, doesn't claim that star ratings are predictive of future performance. "However, many investors appear to depend on these ratings when making fund decisions," says Haslem, noting that high ratings are associated with large fund inflows. But that can backfire. "When a fund goes from four to five stars, it often gets flooded [with new assets]," says Michael Rebibo, president and CEO of 1st Portfolio Wealth Advisors in Vienna, Va.

BEFORE YOU TURN YOUR NOSE UP to a one-star fund or get star-struck by another, understand what's behind the rating. First, keep in mind that stars are doled out on a curve, with 10% of funds in any given category getting five stars, 35% getting three stars, and 10% getting just one star. An otherwise lousy fund could get four or five stars as long as it's better than the rest of its group. It's all relative.

Also, consider the timing, which is based on trailing returns across different periods. Funds that have been around for a decade or more, for example, are graded on a combination of their 10-year, five-year, and three-year trailing returns, with half of the weighting given to the 10-year number. Historic returns are useful, but not if the manager who built that record is no longer at the helm, says John Moore, principal at John Moore & Associates in Albuquerque, N.M. "In general, if the lead manager leaves, we're leaving too," Moore notes.

Consider the T. Rowe Price Health Sciences Fund (ticker: PRHSX). Its longtime manager, Kris Jenner, stepped down early last year, prompting Morningstar to downgrade its analyst rating to neutral. Yet, it still boasts a five-star rating.

In fact, if you're looking for guidance, the analyst rating (negative, neutral, bronze, silver, and gold) is a far better gauge, encompassing everything from historical returns and fees to investment process and the overall culture of the firm. "The star rating gives you a very quick way of seeing where a fund has been, and the analyst rating is where we think the fund is going," says Russel Kinnel, director of manager research from Morningstar, noting that 55% of gold-rated U.S. equity funds were in the top quartile of their categories for 10-year trailing returns through August.

Just because a fund hasn't been rated by an analyst doesn't mean you should ignore it. Only 1,100 of the more than 7,000 funds in Morningstar's universe have analyst ratings, and top priority is given to the largest funds. Likewise, "this isn't a suitability test," says Kinnel. "Just because a fund is gold-rated, doesn't mean it's a good choice for you." 

E-mail: sarahvonmax@gmail.com