Monday, September 8, 2014

Mutual Funds Five Star Curse

There was an article in the Wall Street Journal this morning on how most funds that achieve a five star Morningstar rating don't eventually lose it:

This makes perfect sense for a number of reasons:

1. Morningstar ratings reflect past performance
2. Most mutual funds are style box investors, meaning they stick to a specific style like large cap value, small cap growth, etc.
3. When their style is in favor they will typically do well
4. When their style is out of favor it is hard for them to do well
5. Styles don't stay in favor forever

So you would actually expect a five star mutual fund today probably won't be a five star fund tomorrow.

Instead of using past performance, like a star rating, to judge whether you should buy a fund or not, you should be trying to figure out if the performance is sustainable.  How did the manager get a five star rating?  Is that something that can be continued?  For example, if large cap value stocks have just had a historic 10 year run and a large cap value manager has a five star rating, how likely is is that the next 10 years would be as good as the past 10 years?  Probably not that likely.

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