Many investors shop for mutual fund investments much like they shop for a car or refrigerator. They do some research and look for the highest rated product in their price range. In the mutual fund marketplace Morningstar has made it easy for investors with their star rating system. For over 25 years they’ve rated mutual funds from one star (the lowest grade) to five stars. Unfortunately investing by the stars may not produce the results many investors expect.
The typical investor in 2012 put most all of their investment dollars into bond mutual funds (and actually sold some of their stock funds). The largest bond fund, and one of the most highly rated by Morningstar, is the PIMCO Total Return fund. At least one of the fund’s share classes was rated five stars, Morningstar also gave it a top analyst rating of Gold and the fund manager, Bill Gross, is a three time winner as Morningstar Portfolio Manager of the Year. Yet investors that bought the fund at the end of 2012 have lost about 3% or more (depending on their share class) through mid-August. Over the same period the average mutual fund has gained 11.0%.
Unlike cars and refrigerators, mutual funds change regularly due to their portfolio composition, manager, asset class performance and other factors. Morningstar’s star ratings are largely based on quantitative data with a heavy reliance on past performance. While it’s easy to quantify the past it’s difficult to predict the future and that’s where Morningstar’s star ratings falter.
In an effort to improve the predictive nature of their ratings, Morningstar introduced five new analyst ratings of Gold, Silver, Bronze, Neutral and Negative. Unfortunately, these don’t seem to be much of an improvement. In looking at the 2013 performance (thru August 14) of the Gold rated funds only 55.3% outperformed their peers while 52.1% of the Negative rated funds outperformed. While this isn’t an exhaustive study of the ratings, it’s clear that many investors put more credence into Morningstar’s ratings than they deserve.
At Vintage we’ve used Morningstar’s research for over 25 years but we’ve paid little attention to their ratings. Picking the better performing mutual funds is challenging and we find that, even with good choices, we can only add 1-2% in better performance to a diversified portfolio. Instead, we focus most of our efforts in the area of asset allocation.
If you’ve read our newsletter or E-News over the past couple years you know we’ve been concerned about the bond market’s very low yields and the likelihood that these “safe” investments could suffer losses as they have this year. The difference in returns this year between stocks and bonds illustrates the importance of asset allocation. Through mid-August the S&P 500 index has gained over 18% while the Barclays US Aggregate Bond index has lost 2.7%. The difference in returns between the two asset classes, over 20% so far this year, offers excellent opportunities to improve investment performance by getting the asset allocation decision right. If you’d like to learn more about our strategies please see our website or call our office for a complimentary meeting.