Readers in the so-called “senior” category will remember Perry Como as one of America’s favorite pop vocalists and television performers, with a career that stretched from the 1940s to the late 1980s. If you’re a youngster, ask your parents and they’ll confirm my story.
In 1952, Como’s song “Don’t Let the Stars Get in Your Eyes” was a hit record. It tells of a young man’s plea to his sweetheart to keep her eye on the ball, i.e., his love for her, or words to that effect, and to not be distracted by others vying for her attention.
Mr. Como was not known for his investment insights, but the song’s title and lyrics translate into very good advice for mutual fund investors. Unfortunately, many fund companies are using Morningstar’s star-ratings in their advertising and fund fact sheets. Even financial writers, who should know better, continue to use these star-ratings when discussing fund recommendations. Worst of all, there’s strong evidence that many fund investors are choosing funds based solely on Morningstar’s stars. It may be quick and easy, but that doesn’t mean it’s necessarily the best way to pick a fund.
Morningstar doesn’t disagree with this assessment and has regularly told its readers so. In a few words, here’s the problem. The star-ratings are purely quantitative, they don’t pick up critical evaluative criteria, and they are backward looking. Morningstar is on record, openly stating that “… the star rating system is a report card, not an aptitude test.”
While it’s nice to see a mutual fund with 4 or 5 stars from Morningstar, I have a better suggestion for selecting top-quality funds, and, ironically, it’s Morningstar to the rescue.
Morningstar’s state-of-the-art, independent analytical investment research covers some 1,700 mutual funds. The breadth and depth of its fund research set a very high evaluative standard that is unmatched in the mutual fund investment industry. This is not to imply that Morningstar is infallible. However, as a reliable provider of investment information, its almost thirty-year track record and wide acceptance by the investment community speak for themselves.
Beginning in November 2011, Morningstar started making life really easy for fund investors by creating its “Analyst-Rating” system that uses five key “pillars” to assess a mutual fund’s investment qualities:
Morningstar talks to fund managers, analysts, chief investment officers, and visits fund companies on a regular basis. Expertise, experience, tenure, and demonstrated skills are evaluated.
The competitive advantages of a fund’s strategies are analyzed. How well the strategy is matched to the manager’s and firm’s skill set?
How strong is the fund company? Manager depth and turnover, the investment culture, quality of research, ethics, directors, and regulatory compliance are all examined.
A long-term record is more predictive of future relative performance. How a fund has performed in different market environments, its risk profile, and consistency of returns are important.
Costs have been a good predictor of fund performance.
Using this methodology, Morningstar breaks down its fund assessments into a ranking by five “medalist” analyst-rated categories – Gold, Silver, Bronze, Neutral, and Negative. Currently, there are close to 200 mutual funds that Morningstar classifies as “Gold,” which it considers to be the equivalent of the “best-in-class” funds. Obviously, thoughtful selections from this elite pool are worth holding for the long haul.
Interestingly, a majority of the Gold-rated funds do not have a five-star rating, and, in fact, a large number carry only two and three star ratings. So, I would strongly recommend following Perry Como’s suggestion and kick the “star-habit.” Focus your fund research on Morningstar’s Gold analyst-rated recommendations for investing in high quality mutual funds.
For more information on Morningstar’s analyst-rated methodology and related mutual fund data go to the “Fund” tab on its website: www.morningstar.com.
Richard Loth is the founder and publisher of the Fund Investor’s Schoolhouse, a mutual fund investing educational platform for individual investors (www.fundschoolhouse.org).