5-star rating doesn't mean mutual fund is a winner
By Vic Kolenc
El Paso Times
Is a five-star mutual fund as good as a five-star hotel? Don't count on it, advises Matthew Morey, associate professor of finance at Pace University in New York. His recently published study of the well-known Morningstar and Value Line mutual fund rating systems for a five-year period concluded that neither system consistently predicted winning funds.
"People kind of get seduced (that) this is a great fund because it got a (Morningstar) five-star rating — similar to other things we evaluate like movies, restaurants and hotels," Morey said. "In general, if a fund gets a high rating, it did pretty well in the past. But in the future, all bets are kind of off."
Value Line says the study was flawed, and Morningstar says it has fine-tuned its rating system to make it better since Morey's study.
There's no doubt high-rated funds get more attention and money. Last year, $157.2 billion flowed into mutual funds with five-star and four-star ratings from Morningstar, according to data from Financial Research Corp. of Boston. By contrast, $91.4 billion flowed out of funds with ratings of three stars or lower.
Chicago-based Morningstar and New York-based Value Line, both investment research companies, evaluate mutual funds. Morningstar uses stars to rate funds: Five stars (best) to one star (worst). Value Line uses numbers: one (best) to five (worst).
"To just buy a fund because it has five stars would be a mistake. A person should be doing more analysis of a fund" before investing in it, said Peter DeSantis, an El Paso financial planner.
Morey tracked 738 stock funds in the Morningstar rating system and 653 stock funds in the Value Line system from 1995 to 2000 and found the highest-rated funds didn't do better than funds rated as average. However, both rating systems did a decent job of predicting losing funds, Morey said. Low-rated funds continued to do poorly in the future, "so you can use these ratings to weed out poor-performing funds," he added.
Jean Buttner, Value Line chief executive officer, said Morey's study was flawed because it had no allowance for changes in funds' rankings in the five-year period examined. "Our system does work," Buttner said. "The Achilles' heel in the Morey study is the notion that an investor cannot change funds."
On the other hand, before Morey's study came out, Morningstar realized its mutual fund star-rating system had lost credibility. That's why last summer, the company released a revamped system in which funds are rated in 48 categories instead of the previous four, and in which more weight is given to a fund's potential downward risk, said Russ Kinnel of Morningstar.
