Mutual Fund Ratings: Crucial or Insignificant?

By Ryan C. Fuhrmann AAA

Mutual Fund Ratings: Crucial or Insignificant?
Many financial services firms try to help investors by sharing their opinions on a mutual fund. In a nutshell, they do a decent job of accurately rating a fund based on its past performance. The downside to this method is it isn’t a good guide to future performance. But can using other information really make better predictions on future fund performance? At the end of the day, there is some value to the approach that fund raters take to rating mutual funds. Investors should use this data as a starting point and combine it with some factors noted below for a more holistic approach to weeding out fund losers from the winners.

Fund Rating Processes
Morningstar (Nasdaq:MORN) runs what is perhaps the best known and most widely used mutual fund rating system for individual investors. Its aptly entitled Morningstar Rating for Funds rates a mutual fund based on how the fund has performed over a three-, five- and 10-year period. It also adjusts for risk (defined by modern portfolio theory metrics that look at volatility measures) and accounts for sales charges that can detract from performance figures. The rankings range from 1 to 5 where 5 is the highest score possible.

Morningstar considers the inner workings of its ratings data points proprietary and doesn’t disclose much detail into how the numbers are crunched. Notable positive points to its approach include looking at longer investment time frames beyond simply days, weeks, months or even one-year periods. Morningstar is also critical of high fees or even those that come in above a category average. Additionally, it popularized style boxes that divide mutual funds by which market capitalization they invest in, or whether they pursue a value, growth or core strategy that mixes growth and value.

Other providers including Lipper and Standard & Poor’s provide fund ratings. Lipper’s rankings look at total historical returns, whether these returns are consistent over time or volatile, and whether a fund is likely to preserve capital over different market cycles. It also considers fees and tax efficiency.
S&P pursues a similar strategy to both Morningstar and Lipper in that it compiles past performance and offers risk adjustments, as well as breaking funds by style and market capitalization. Other mutual fund ratings providers try to improve off the key players, but many integrate ratings from the above “big guys” and use similar metrics. Overall, the key ratings factors include past performance, attempts to handicap returns by risk and fees, and methods to group funds with similar strategies or focuses.

The Benefits of Fund Ratings
Mutual fund ratings are popular for many important reasons. For starters, they let an investor get to a quick-and-dirty opinion on a fund within minutes. Morningstar’s rating process has become extremely popular and is used by investors and investment managers alike who like to tout that their funds possess four- or five-star ratings, for instance. Ratings are also great at detailing past performance, which is obviously quite easy to track and publish. Clearly, it is very straightforward to give a low rating to a fund with terrible historical performance. The style box also makes it easy to see how a fund invests and which investments are held in a fund.

Mutual fund ratings providers also serve as industry watchdogs, which can help keep fund companies honest. For instance, they provide reviews on mutual fund boards, look at the backgrounds and tenures of portfolio managers, and detail whether a fund is remaining true to its investment style, as measured by where it stands in a style box.

Drawbacks
Many of the benefits of mutual fund ratings are also drawbacks. They make fund investing look easy, but are a one-size-fits-all system that doesn’t consider enough factors. There is also a certain herd mentality in mutual fund investing and a heavy reliance on style boxes. For instance, a fund may get dinged for emphasizing large cap stocks when it is categorized in the mid-cap space. Even though larger companies may be better buys, a fund manager may avoid them for fear of being outside of his respective style box. This investment mentality gives consultants undue influence on the fund selection process, which can ingrain these inefficiencies into managing funds.

Another key criticism includes an emphasis on past mutual fund returns, which the financial services industry points out is not a great indicator of future performance. Morningstar has even admitted the emphasis on backward-looking data for its ratings process.

Measuring risk through stock market, individual security and portfolio volatility, including overall risk measures such as standard deviation and market risk through beta, is not always the best approach at tracking risk. For instance, in severe downturns, as occurred in 2008 and early 2009, correlations among many investment assets were much higher than during more normal market climates.

Fund ratings also aren’t always selective enough. One article critical of the ratings process estimated that the Morningstar five-star rating is awarded to 10% of funds in each of its categories. Among thousands of mutual funds, many hundreds receive a top rating. More importantly, the process results may not have much predictive value. We will cover this in more detail below.

What Do Fund Rating Track Records Tell Us?
Studies have analyzed whether mutual fund ratings help predict out and underperformers. One such study did see value in the low end of Morningstar’s ratings. Namely, funds ranked at three stars or below generally underperformed in the future. However, the study concluded that there was only weak statistical evidence that its four- and five-star fund ratings indicated strong performance going forward. It also detailed that this supports similar studies, which means that Morningstar’s shortcomings are a common occurrence. In short, it’s tough to use past performance to predict the future with much certainty.

Morningstar has attempted to improve its rating system. It even created one to integrate its backward-looking ratings with data that attempts to make some prediction about future performance. This system uses a bronze, silver or gold ranking that is now listed on its website and looks at such factors as the people managing a fund, its investment process, and overall track record of the firm that owns the fund.

Bottom Line
Mutual fund ratings are valuable, but they should only serve as a starting point for investors. Overall, ratings provide insight into a fund, how it has performed in the past and how it invests. But investors need to do their own homework and integrate this information into an estimate of how a fund might perform in the future. Important considerations are fees and how funds have performed over the long haul, ideally through a full market cycle.

The best advice may be that, regardless of a fund rating, most mutual funds underperform their indexes over time. This is due to index hugging, meaning many hold too many stocks and don’t utilize enough active management, or simply picking stocks that are likely to outperform. High fees are another major killer of performance. For investors, learning not to chase performance (by buying funds that have done well in the past) and avoiding attempts to time the market can boost performance over time.

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