Mutual Fund Ratings: Are They Deceiving?

By Michael Schmidt AAA

Mutual funds have provided a wide variety of investment styles and strategies for many years. In fact, the number of mutual funds has almost eclipsed the actual number of stocks traded in the stock market. This broad offering of products has presented a challenge to both retail and institutional investors, as they try to determine the best funds to reach their desired results in each respective asset class.

The mutual fund rating business has blossomed from a quarterly rating service to a multimillion dollar industry. Rating agencies provide a valuable service to customers and keep the fund managers on their toes with constant scrutiny, which can make or break a fund's success. Still, while the ratings are important to investors, they can be deceiving. In bear markets, a high-rated fund can perform just as well (or a badly) as a low-rated fund can, regardless of strong performance in a bull market. (For more background information, see A Brief History Of The Mutual Fund.)

The Lipper Rating System
Lipper provides mutual and hedge fund reviews, commentary and tools used for screening and analyzing data. While Lipper services the institutional and asset management industry, its mutual fund services are provided in detail for retail investors of all levels. Lipper's proprietary rating system, Lipper Leaders, covers more than 80,000 funds and uses consistency, capital preservation, peer performance and expense management as its tenets, among other factors. The Lipper ranking system is based on a scale of one to five (with five being the highest rating). Lipper Leaders are the funds that rank in the top 20% of their peer ratings, with the next 20% receiving a rating of four, and so on. (For more, see Benchmark Your Returns With Indexes.)

The Morningstar Rating System
Morningstar also uses a ranked system, but it uses stars instead of numbers as the rating standard. Also similar to Lipper, Morningstar offers both online and hard copy reports tailored to specific investors' preferences. Morningstar also created a nine-square style box for both equity and fixed-income funds, which depicts styles and size categories. Morningstar presents breakdowns for equity funds into 12 industry groups inside three primary economic sectors to compare weighting decisions. (For more information, see Morningstar Lights The Way and Understanding The Style Box.)

Chasing Performance
Performance is likely the most recognizable component of mutual fund ratings. This component by itself is easy to follow and does not require in-depth knowledge of the market. However, "chasing performance" has led many investors into what is known as the "performance trap." This is when money flows heavily into a fund that was highly rated in the previous year. More often than not, that same fund does not repeat such impressive numbers in the following period. In this situation, consistency comes into play and rating firms add some value. Ratings firms will apply expertise and evaluate a fund's performance on a relative and absolute basis.

Because different investing styles tend to display varying results over market cycles, new styles can be extremely important to an investor. The rating companies can add much value here, as it is not a good idea to leave style analysis up to the fund manager.

The Downside of Ratings
One of the biggest problems with mutual fund ratings is that during a long-term bull market, investors and those who rate funds can easily become complacent. During volatile market times, mutual funds managers are susceptible to any temptation to try to increase performance or protect against downside risk; both factors can lead to rogue trading, or even fraud. (For more on fund risk, see How Risky Is Your Portfolio?)

Also, due to the lengthy process of becoming a highly-rated fund, up-and-coming funds may not be recognized in time to make a substantial investment in their early period. (For more, see Stock Ratings: The Good, The Bad And The Ugly.)

The Bottom Line
The business of evaluating mutual funds has evolved into an industry in itself. Mutual funds are evaluated on many levels beyond just performance, including peer group comparisons, sector weightings and cash holdings. Though not infallible, ratings systems can provide investors with relative guidance and direction that can lead to decent returns. (For further reading, see Don't Panic If Your Mutual Fund Is Drifting and Digging Deeper Into Mutual Fund Names.)

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