Our Insights

About personal finance, investments and markets.
December 6, 2016

5 star funds equal better performance?

It seems a familiar part of the investment process: an advisor steers his client to a new fund and refers to the five-star rating as a key selling point. But does a higher rating actually imply a better long-term performance than a lower rating? Morningstar has thankfully run the numbers on the star rating’s predictiveness. The study, which measured funds’ subsequent returns, showed no proof that the star rating has any predictive power over a five year horizon.

In fact, cumulative 5y returns were higher for 4-star funds than for 5-star funds. Equally, 1-star funds performed better than 2-star funds. Investors need to be careful when using fund-rating tools to forecast returns. There is very little predictive value in Morningstar’s fund rating.

Average cumulative return over 5 years – all asset classes

 1 star2 stars3 stars4 stars5 stars
Cumulative 5 year return28.56%28.30%28.87%29.65%29.22%

In fairness to Morningstar, they are very clear that the star rating should not be seen as prognostication tool. The real problem lies with advisors who either use it incorrectly or simply don’t understand the method behind the rating.

The star rating distills several factors into one easy-to-use measure. But those indicators are by definition always backward looking. Still, the star rating can be a good starting point to help investors cut a larger universe of investment options down to size, clearing the way for more-detailed research from there. But it should not be the only tool investors use nor should it be at the heart of the decision making process.