How relevant or accurate are Morningstar "Star" ratings for mutual funds?Morningstar is a leading site for finding and researching mutual funds. The simplest differentiation between funds that I have seen is the Morningstar "Star" rating.
Does anyone know the methodology behind the ratings or how relevant they are when doing a comparison between 2 funds?
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It's a good screening device.
From Morningstar [1]:
[1] http://news.morningstar.com/articlenet/article.aspx?id=269048&page=%252ffundpickperformSpecifically, it measures load-adjusted total returns from the past three-, five-, and 10-year periods. Then it adjusts for risk so that high-risk funds are taken down a peg or two, and low-risk funds are moved up a bit. The risk-adjusted measure is then graded on a curve within a category. We give 5 stars to 10% of the funds, 22.5% earn 4 stars, 35% take the 3-star rating, 22.5% take 2 stars, and 10% earn 1 star.
Terrible. I returned it to the library or I'd quote it, but Morningstar did not fare well in Jeremey Siegel's Stocks for the Long Run. The jist, as I remember it, is that while retail investors follow it slavishly, the ratings don't do so well in the long run.
The reason is pretty simple: past performance is not indicative of future results.
Hmmm... from the same Morningstar page:
The same is true for batting averages--a measure of what percent of funds beat their peer group averages, though in our example of domestic-equity ratings from 2003, there was a surprise. We saw 54% of 5-star funds beat their peers over the next five years.
If I'm understanding this right, 46% of those 5* funds did worse than their peers. So you have about a 50/50 chance of beating a random fund in that class (a peer). That doesn't seem very predictive at all.
Practically speaking, they are a good first step. I've found that the value of this and other rating system lies more in being able to eliminate the duds right away rather than in making the final choice.
