Seven Things Investors Should Know About Mutual Fund Ratings
By Richard A. Weiss
Chief Investment Officer, City National Bank

Many investors turn to rating systems, such as Morningstar, to gauge how their mutual funds are doing. Rating systems are very popular with investors and often are used as the sole determinant of whether to invest.

Unfortunately, most investors are not clear that Morningstar should be used only as an initial screen. At City National Bank, our disciplined fund evaluation takes many factors into consideration, and rating systems play a very small role, if any, in our assessment of whether a fund can consistently produce superior returns in its asset category. Here are seven things investors should know about Morningstar ratings:

1. The star rating is return-based. Although there is a risk adjustment, stars are based on returns. Therefore, the three- and five-year star ratings are biased toward those funds that simply performed the best over the most recent three- and five-year periods. Investors should look at much longer term ratings and the consistency with which funds have achieved their objectives. Too often, a fund has a superior 10-year track record simply because it hit a home run in only one of those years.
2. Style drift is not taken into account. For example, a small cap equity fund that “drifts” into large cap stocks – or even changes its official asset category classification entirely to large cap – is measured against its latest assignment. This is a significant disadvantage to funds that remain consistent with their stated objective. Investors should carefully examine a fund’s full history.
3. Morningstar’s risk adjustment penalizes downside risk but also upside potential. A fund cannot eliminate downside “risk” without also limiting upside potential. In addition, the star system is biased toward those funds that exhibit lower risk in general – a welcomed feature only in a bear market.
4. The fund categories are too broadly defined. Broad categories can result in an “apples to oranges” comparison.
5. Portfolio manager changes are not taken into account. If a portfolio manager leaves a fund, the star system has no way of incorporating this information.
6. Key factors such as fund diversification, fund size, turnover, liquidity, style and return consistency are NOT directly incorporated in the star ratings.
7. The star system, as currently designed, does not distinguish manager skill from luck. More stars only imply higher returns over a selected time period. Whether, and to what extent, a fund’s historically superior returns continue to be attractive or even competitive in the future requires significant additional research beyond the Morningstar rating.

This article is for information and education purposes only and does not constitute a personal recommendation or take into account the particular investment objectives, financial situations or needs of individual clients. Clients should evaluate the merits and risks associated with relying on any information provided.