The stars are not aligned

July 18, 2013 Categories: Portfolio Corner
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Earlier this year, we began a series of posts about “the perils of buying past performance,” since we know investors commonly fall prey to this behavior. In the first post Chasing Stars in Investors’ Eyes we put numbers to the phenomenon, discussing the disproportionate amount of cash flow gathered by highly-rated mutual funds presumably because investors think these funds are superior.

In talking to clients who believe this myth, you might want to begin by acknowledging that the misconception that highly-rated funds will continue to outperform is a common one, but also come prepared with information that dispels it. We intend here to arm you with facts you can use in that conversation.

Most investors are familiar with the standard disclosure that accompanies every representation of mutual fund performance: “Past performance is not a guarantee of future returns.”

But do investors believe it? Do they invest accordingly?

As highlighted in the first post of this series, highly-rated funds – i.e., funds that have performed well in the past – gather disproportionately large sums of money. So, the average investor must not pay any attention to the famous disclosure, right?

It’s more likely that the average investor doesn’t know fund ratings are a function of past performance. In fact, the average investor likely equates fund ratings with product review services associated with other buying experiences – something like a Consumer Reports* rating of a car they might purchase.

In fact, it is nothing like that.

Yes, both are evaluating a product against its peers. However, they maintain two very important distinctions:

  1. Fund ratings are typically based only on past performance, while Consumer Reports rates a car based on many different quantitative and qualitative factors (e.g. owner satisfaction, reliability, comfort/convenience, fuel economy, etc.).
  2. Fund ratings are not intended as a forecast of future reports, while Consumer Reports ratings are intended as a forecast of how well a product will meet a consumer’s needs in the future.

When investors see a highly-rated fund, many apply the holistic methodology they are used to from other expert review services. They likely assume that – like Consumer Reports – the ratings include other important factors such as manager talent, tenure, style drift, investment process, etc.

A conviction that one should restrict fund selections based solely on their fund rating is the same conviction that past performance is indicative of future returns. Even if they invest according to the former conviction, many investors don’t know they are adhering to the latter.

To dispel the myth that fund ratings indicate future results, the following infographic shows if fund ratings translate to value the next year. (For more technical readers, it’s showing absolute returns in 2012 for groups of differently rated funds, as Morningstar rated them at the end of 2011 based on risk-adjusted returns.)

Click image below to view a PDF of the infographic.

Fund ratings infographic

Based on Morningstar Overall Ratings. Includes all mutual funds in the Morningstar rating universe.
Source: Strategic Insight’s Simfund MF 5.0 database, as of 12/31/12

Here are three key observations from these charts:

  1. Notice the overlap: A significant portion of the range is occupied by multiple star-groups. Any performance differentiation between the groups is generally very slight.
  2. Notice the parity: A different star-group hosts the best performing fund and the best group average return in each fund category.
  3. Notice the purple: In each fund category, the best return did not come from a 5-star fund. Also, the 5-star group didn’t have the highest average in any category.

So if one of your clients wants you to restrict your choices to only highly-rated funds, you are correct to discourage them from doing so on the basis that fund ratings have little bearing on the fund’s relative value going forward. Or to put it in more familiar terms, past performance is not indicative of future returns.

Use this chart to help you have that meaningful, level-setting conversation.

Stay tuned for the next post, where we’ll see how differently-rated funds have performed relative to each other over a longer time period.

The bottom line

Create context for your clients

When your clients focus on star ratings remind them that assessing current and prospective investments in an outcome-oriented portfolio requires a multi-faceted review, and star ratings only evaluate past performance. As we all know, past performance is no guarantee of future returns.

Description of Morningstar’s Rating Methodology: For each fund with at least a three-year history, Morningstar calculates a Morningstar Rating based on a Morningstar Risk-Adjusted Return measure that accounts for variation in a fund’s monthly performance (including the e¬ffects 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.

*Consumer Reports is an American magazine published monthly by Consumers Union since 1936. It publishes reviews and comparisons of consumer products and services based on reporting and results from its in-house testing laboratory and survey research center. It also publishes cleaning and general buying guides. Consumer Reports is used in this presentation for illustrative purposes only.

1 The size and composition of each category does not necessarily remain constant from one year to the next. Funds may or may not maintain the same star rating from Morningstar over the time frames represented in the chart. Funds may or may not remain in the same fund categories over the time frames represented in the chart. Funds may or may not have liquidated/closed over the time frames represented in the chart.

2 Standard performance for Morningstar categories mentioned above (for context, see footnote #1):

The stars are not aligned disclosure table

Performance quoted represents past performance and does not guarantee future results. The investment return and principal value of an investment will fluctuate so that shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted.

4 Substantiated by the fact that investors put net positive $390 billion into 4- and 5-star funds in 2012, versus net negative $111 billion into 1-, 2-, and 3-star funds in 2012.

® 2013 Morningstar, Inc. All Rights Reserved. The information contained herein: (1) is proprietary to Morningstar; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results.

“Number of funds” reported in the charts above do not count each share class of a fund portfolio separately. Rather, “number of funds” reflect the number of fund portfolios rated by Morningstar. Morningstar’s portfolio-level ratings reflect the rating of the portfolio’s primary share class. If the portfolio’s primary share class does not have a rating, Morningstar uses the rating of the share class with the most assets under management.

Performance data, Morningstar category names, star ratings, and the Morningstar name are © 2013 Morningstar, Inc. All Rights Reserved, and (1) are proprietary to Morningstar; (2) may not be copied or distributed; and (3) are not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results.

A fee and expense waiver may have been in effect for the time periods listed and if applicable, for all time periods shown. For the funds with a waiver, it had a material effect on performance. Had the waiver not been in effect, the Fund performance would have been lower.

Data sources: Morningstar and Strategic Insight via Strategic Insight’s SIMFUND MF 5.0 database, data pulled as of 1/31/2013

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