The stars are (still) not aligned

February 18, 2014 Categories: Portfolio Corner
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Last year, we explored the perils of buying past performance with our infographic on the performance of Morningstar®-rated funds over time. We recently updated this infographic with data from 2013, and we weren’t surprised that it tells the same story: past performance is no guarantee of future returns.

These charts expose why star ratings or other backward-looking evaluations shouldn’t be relied on by investors as the primary factor in choosing a mutual fund. Check out the new version below and our update on the three elements explored in previous posts: what investors may do with ratings, ratings perceptions versus reality, and performance over time.

Click image below to view a PDF of the full infographic.

Morningstar inforgraphic

What investors may do with ratings

We isolated the groups of all 1-, 2-, 3-, 4- and 5-star funds as rated by Morningstar at the end of 2012 – and compared how much money investors entrusted to those groups over the course of 2013.

As was true in 2012, highly-rated funds gathered the majority of cash flow in 2013. Specifically, on average 5-star funds gathered $187 million per fund in 2013 and 4-star funds brought in $144 million per fund. Meanwhile, 1- and 2-star funds each lost money as groups.

Ratings perceptions versus reality

We compared the relative 2013 performance among 1-, 2-, 3-, 4- and 5-star groups within the same Morningstar category.

Notice the overlap. A significant portion of each range is occupied by multiple star-groups. Any performance differentiation between the groups is generally very slight.

Notice the parity. No single star-group consistently ranks highly in every Morningstar category.

Notice the purple. Contrary to what investors seem to believe (evidenced by cash flow to highly rated funds), the 5-star group doesn’t always win.

Performance over time

Finally, we isolated 1-, 2-, 3-, 4- and 5-star groups from 2002 and compared how each of those groups performed in the next 11 years ending Dec. 31, 2013.

No single star-rating predicted a consistent outperformer. Likely contrary to common belief, the 1-star class of 2002 beat the 5-star class for a majority of the years shown in the chart.

Notice the closely grouped returns across star-rating groups each year. There is very little performance differentiation among the classes of 2002.

The bottom line

You can use these charts to create context for clients who tend to focus on backward-looking information. Help them understand that assessing current and prospective investments in an outcome-oriented portfolio requires a multi-faceted review, and star ratings only evaluate past performance.

For more insights, be sure to revisit past posts that articulate some of the top insights from this infographic.

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. The analysis of these and other categories may produce different results and vary over time.

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

Morningstar disclosures

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.

3 Based on calendar-year, fund-weighted-average absolute returns for each star-rating group, as it was rated at the end of 2002. Each annual absolute return value includes the original constituents of the star-rating group as it was rated at the end of 2002, less those constituents that liquidated/closed prior to the end of the year for which the annual absolute return value is calculated.

4 Substantiated by the the fact that investors put net positive $283 billion into 4- and 5-star funds in 2013, versus net negative $95 billion into 1-, and 2-star funds in 2013.

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 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.

® 2014 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 © 2014 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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