The long ‘tale’ of shooting stars
A mutual fund’s rating is intended to evaluate a fund’s past performance in the context of its peers, and not to indicate the fund’s relative value going forward. (Or, as the often-cited disclosure reads: “Past performance is no guarantee of future returns.”) As we discussed in the most recent post in this series, the evidence supports this — at least on a year-over-year basis. But what about over the long term? Here we continue to follow the classes of 2001 as they were rated at the end of that year by Morningstar.
Take a trip back in time to the end of 2001. Suppose you’ve decided to choose a new fund for your client’s portfolio, and your standard practice is to only choose funds that are rated above average. So you restrict your initial search accordingly, finally settling on a 5-star fund and you hold on to it for the long term.
Fast-forward 11 years to the end of 2012. How did that fund perform throughout the years, especially compared to its lower-rated peers? In the charts below, we take a look. (Follow the purple in the charts to see how 2001’s 5-star class performed on average.)
Click image below to view a PDF of the infographic.
To be clear, here we are comparing year-to-year performance for the average 1-, 2-, 3-, 4-, and 5-star funds from 2001 – as deemed by Morningstar based on prior risk-adjusted performance. We’re looking at the average absolute returns over 11 years ending 12/31/2012.
Two observations from the charts above:
- There is no consistent outperformer. No single star-rating predicted an outperformer year after year. The average 5-star fund finished first one year, last one year, and everywhere in between. Interestingly, the low ranking 2-star fund class of 2001 finished ahead of the top ranking 5-star fund classes in a majority of years.
- Similarity of fund returns. Notice how tightly the average returns are grouped each year. There is very little performance differentiation among the star-rating classes of 2001. Even in 2004 when the average 5-star fund from 2001 performed best, it was only 52 basis points better than the runner-up.
Another consideration not highlighted by the charts is the deterioration of the groups, and the likelihood that a highly-rated fund choice won’t even be around for the long haul. For example, at the end of 2001, 598 funds were given 5 stars. However, 144 of those (roughly 24%) don’t even exist any longer, having been closed/liquidated/merged at some point over the past 11 years.
All of this illustrates the central point that selecting a mutual fund requires a certain level of qualitative due diligence — a level not accomplished by fund ratings alone. This qualitative analysis involves a rigorous process of researching and choosing a fund based on a combination of many factors.
The bottom line
Create context for your clients
Generally, fund ratings are great for evaluating a fund’s performance history, but they’re certainly not intended to be a crystal ball. The evidence in the infographic indicates that while ratings may play a part in the research phase when selecting a fund, they certainly shouldn’t play the central role.
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.
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 Based on calendar-year, fund-weighted-average absolute returns for each star-rating group, as it was rated at the end of 2001. Each annual absolute return value includes the original constituents of the star-rating group as it was rated at the end of 2001, less those constituents that liquidated/closed prior to the end of the year for which the annual absolute return value is calculated.
® 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