NEW YORK (MarketWatch) -- Tim Courtney decided he'd had enough. In meeting after meeting this year, he and his colleagues at Burns Advisory Group had recommended mutual funds to prospective clients, only to be hit with the same response almost every time: Why are you telling me to invest in a three-star rated fund?
That sums up the way many investors allocate money to funds -- look at products that have four- or five-star ratings from investment researcher Morningstar Inc., take that as an imprimatur of quality and hope for the best.
Such decisions are perhaps even more common in volatile markets, when anxious investors view top-ranked funds as somehow better-equipped to handle adversity.
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Five-star funds in particular seem to have their own allure. Even in 2008's brutal market, when the other star-rated funds saw net outflows ranging from $111 billion for three-star funds to $14 billion for four-star funds, five-star funds enjoyed $67.5 billion in net inflows.
The trouble is that investors seem to forget that star ratings look backward based on a fund's past performance, and studies have shown the ratings have no predictive value. "Having to get over that hurdle [explaining how star ratings shouldn't influence choices], every time we recommended a fund that wasn't five-star, is something we have to do time and time again," said Courtney, chief investment officer of Burns Advisory, which manages about $300 million and advises about $150 million of 401(k) assets.
So Courtney and his colleagues went back to Dec. 31, 1999 and studied the subsequent 10-year performance of five-star funds. What he found might convince investors to kick their star-rating habit.
Of the 248 stock funds with five-star ratings at the start of the period, just four still kept that rank after 10 years. The 218 domestic stock funds with the rating typically lagged their category averages over the period -- not just the benchmarks, but other mutual funds. The exceptions were 30 foreign large-cap funds, which had a 10-year annualized return of 1.44% compared with their category average of 1.32%. In other words, it's not just that five-star funds don't, on average, continue to lead their peers, but they actually do worse in subsequent years.
The worst performers were small-cap growth funds. The category's 29 five-star funds in 1999 lost an average of 3.6% annualized over the next decade. The category overall was up 0.6% in the period.
Don Phillips, managing director at Morningstar, took exception to Courtney's findings. He said that Morningstar changed its star-rating methodology in 2002 in response to problems that became apparent as the tech bubble burst. The biggest change was using 48 categories, rather than four, to compare funds to those using similar strategies.
A study of returns after the changes were made would find different results, according to Phillips, who noted that one study found that from 2002 to 2005 better-ranked funds outperformed funds with a lower rating.
"The fact that Morningstar changed their methodology [subsequently] would have not changed the outcome of those funds that were five-star rated on Dec. 31, 1999," countered Courtney. "Although you could certainly say that if the old methodology were still in place, more than four funds may have retained their five-star ratings."
He added: "Regardless what the method is, the star rating in our opinion should be used by investors with the knowledge that the rating should serve as only one piece of the research process."
Stars come out
Courtney's findings will have to go a long way before investors lose their starry eyes. Four- and five-star rated funds captured about 72% of the roughly $2 trillion of net inflows into all funds with star ratings over the decade through Dec. 31, 2009, according to Morningstar. Thirty percent went into three-star funds, while less than 1% went to two-star funds. (The numbers add up to more than 100% because of net outflows from one-star funds.)
There are valid reasons for inflows numbers, such as the fact that some extremely good funds are four- and five-star rated. But the figures also suggest a strong element of performance-chasing -- returns that by definition are in the past and may not be repeated.
Rather than performance, Courtney said he looks for relatively low costs and low turnover in a fund, along with investment strategies he understands and which the manager doesn't frequently change. In addition, he also prefers diversified, rather than concentrated, portfolios.
Morningstar's Phillips commented that critics of star ratings overlook the fact that better-ranked funds are also typically the cheapest funds with the lowest turnover. He noted that on average, the better-rated funds also hold more of their manager's personal investments.
Phillips acknowledged the ratings are imperfect as the sole determining factor, but said that he believes they are as good a short cut as people have when it comes to picking funds.
Courtney, for his part, takes issue with the myopic focus some investors place on the rankings. "Investors use the star ratings to the exclusion of other data," he said. "It's very frustrating."
(Sam Mamudi is a reporter for MarketWatch, based in New York)
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