Chasing stars in investors’ eyes
Over the coming months, we will publish a series of posts that continue the theme of the perils of buying past performance, as initiated by the infographic in this post. We will research and share ranges of investment outcomes for mutual funds, separating and comparing them by Morningstar rating.
In this first edition of the series we highlight the disproportionately large amount of money that highly rated funds gather, identifying a potentially unfounded investor perception of fund ratings.
Imagine you’re sitting down with a client, going over their financial goals and the investments you’ve put in place to hopefully achieve them. You’re introducing a new fund to them, or perhaps you’re discussing the performance of a fund currently in their portfolio.
“So, what’s the star-rating?” they chime in, unsolicited.
“Well, Morningstar has given it a three-star rating,” you respond, “but we typically focus on other ––”
“I guess average isn’t too bad,” the client interjects. “But I see there are a handful of 5-star funds in the same category available to us here. Why don’t we pick one of the best?”
Have you ever had to deal with this type of objection? For better or for worse, conversations head this direction quite often.
Of course, the investment industry (and the investors they serve) pay close attention to what firms like Morningstar, Lipper and other rating agencies have to say about mutual funds. Fund providers regularly highlight fund ratings in their marketing and advertising campaigns, encouraging investors to focus there when considering a fund.
Many self-directed investors actually limit their choices to only 4- or 5-star funds when deciding to replace a fund they’re currently using or when choosing a new fund.
As you can see in the chart below, this behavior is unmistakably reflected in fund flow data. Investors pour money into 4- and 5-star funds. And a lot of it.
To be exact, 4- and 5-star funds gathered $390 billion in 2012. In fact, only those highest-rated groups attracted positive net cash flow last year. By comparison, 1-, 2-, and 3-star funds each experienced net outflows as groups.
On average, the group of 5-star funds brought in $445 million per fund while the 1-star group lost $39 million per fund.
This phenomenon is not unique to 2012. It consistently displays the high level of trust and deference investors give to fund ratings. Industry flows suggest investors generally assume that higher rated funds are more likely to deliver better results than their lower-rated counterparts.
Stay tuned for the next post in this series where we’ll investigate what naturally follows, “Does this assumption prove to be true?”
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For each fund with at least a three-year history, Morningstar calculates a Morningstar Ratingä based on a Morningstar Risk-Adjusted Return measure that accounts for variation in a fund’s monthly performance (including the effects of sales charges, loads, and redemption fees), placing more emphasis on downward variations and rewarding consistent performance. The top 10% of funds in each category receive 5 stars, the next 22.5% receive 4 stars, the next 35% receive 3 stars, the next 22.5% receive 2 stars and the bottom 10% receive 1 star. (Each share class is counted as a fraction of one fund within this scale and rated separately, which may cause slight variations in the distribution percentages.) The Overall Morningstar Rating for a fund is derived from a weighted average of the performance figures associated with its three-, five- and ten-year (if applicable) Morningstar Rating metrics.