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September 14, 2015

Are star ratings the best way to choose a fund?

Many investors use the Morningstar fund rating system to pick their investments. This is understandable because there are currently more than 9,000 mutual funds available in Germany alone and most private investors are simply overwhelmed by the choice. A simple star-rating, similar to the one employed by film critics, seems like a useful objective tool to narrow down the list of potential investments. It is no accident that advertisements touting four- and five-star ratings can be found almost everywhere in the financial media. Investors believe that the number of stars earned by a mutual fund posseses predictive value. However, this is incorrect – even Morningstar says that their star rating is no reliable predictor of future outperformance.

Past is no prologue

Morningstar itself conducted a study to examine the degree to which the well-known star rating system is a predictor of mutual fund outperformance. The results showed that “there is little statistical evidence that Morningstar’s highest-rated funds outperform the next-to-highest and median-rated funds”. The rating cannot predict superior fund performance.

Best-rated funds consistently underperform the worst-rated funds

Fund flows show that investors clearly favour higher-rated funds and shun lower-rated funds. However, Vanguard (largest fund manager in the US) has found out in a study that highly rated funds in one rating period tended to be the worst performers over the next 3 years. Surprisingly, the relative underperformance got less pronounced for funds with fewer stars – exactly the oppositive of what would have been expected if the Morning star-rating had any predictive value.

Vanguard Morningstar

So what is in the (Morning-)Stars?

Morningstar’s mutual fund ratings debuted in 1985 and quickly became a popular metric amongst investors and advisors. Star ratings provide a simple method of comparison. But what does it actually tell you about a given fund? Morningstar ratings are designed to bring returns, risks, and adjustments for sales loads together into one evaluation. In essence, the rating system evaluates PAST risk- and cost-adjusted returns to the average investor but it tells investors nothing about the future. It actually isn’t fair to critisize the Morningstar star-rating system for its failing to predict future outperformance – it was never set-up to do that.

Summary

The allure of something—anything—that could potentially help us do better is strong. But unfortunately all studies show that choosing funds on the basis of their (Morning-) star rating is not the right way to go. The bottom line: if you are still relying on the past performance of actively managed funds to build your investment plan, it’s time to stop.

So what’s an investor to do who cannot evaluate a fund manager on qualitative terms? According to studies conducted by Morningstar and Vanguard, all evidence demonstrates that by looking for funds with a lower expense ratio, you’ll do better than by seeking out funds with a great Morningstar rating. All other things being equal, the smaller a fund’s expense ratio, the better the results obtained by its holders.

 

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