Friday, May 28, 2010

Mutual Funds: It's All About the Stars

A fascinating read via CBSMarketwatch on how Morningstar's "stars" have come to dominate the industry. Being a mutual fund investor of one sort or another since the late 80s, this struck me - while I look at performance, the stars mean nothing to me. But it looks like in K.I.S.S. world, people want something easy and digestible and stars it is! The fund flows by stars really got to me, especially considering many fund flows are 'locked' into small subsets in 401k plans... which tells me if you exclude those funds within 401ks (in which case the investor is 'captured' and thus has fewer choices), the performance chasing is even greater outside 401k plans than the figures in this story.
  • Tim Courtney decided he'd had enough. In meeting after meeting earlier 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 a seal 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.
  • 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 are backward-looking, based on a fund's past performance...
  • Courtney and his colleagues went back to Dec. 31, 1999 and studied the subsequent 10-year performance of five-star rated 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. And the 218 domestic stock funds with the rating typically lagged their category averages over the period -- not just the benchmarks, but other mutual funds. (I will assume a lot of this is massive asset inflows which make keeping performance going very difficult) In other words, it's not just that five-star funds don't, on average, continue to lead their peers -- they actually do worse in subsequent years.

Some amazing statistics:
  • But 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, for instance 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.
  • "Investors use the star ratings to the exclusion of other data," he said. "It's very frustrating."

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