Morningstar's Top Rated Funds Unlikely To Give Investors Best Returns

By Tom Madell

When investors are in a quandary as to the best mutual funds to own, they frequently turn to expert sources to help them make their decisions. And for fund investors, there is usually considered to be no more of an expert source than the Morningstar.com site. While the Morningstar site certainly provides highly valuable data on mutual funds and ETFs, when it comes to perhaps one of their most widely used features, that is, their highly popular, and seemingly easy-to-grasp fund ratings, investors need to have their eyes wide open.

When first introduced back in 1985, these ratings consisted solely of mathematically derived and adjusted past performance indicators, called star ratings, yielding anywhere from 5 stars, the highest rating, down to 1 star, the lowest, reflecting a backward-looking measure of past performance in comparison to other funds of the same category. According to some sources (e.g., see here), this prominently displayed feature for funds has been widely embraced by analysts, investors, and fund companies themselves in advertising high ranking funds.

However, many research studies and even Morningstar itself concluded that such backward-looking data provided rather minimal usefulness in predicting future performance results. After all, a truism of investing is that past performance is not a reliable predictor of future performance.

Therefore, beginning in late 2011, Morningstar introduced a new rating system called "Analyst Ratings." In brief, the idea was to not only look at past performance but several other variables they considered would be much more determinative, in total, of future performance, that is, "foreward-looking" measures with more presumed predictive ability, as compared to backward-looking ones.

Investors can find detailed descriptions of Analyst Ratings on the Morningstar.com site. (For example, see here.) There, you will see that presumably expertly-derived, but still subjective, positive ratings of "Gold," "Silver," and "Bronze" mean "Morningstar analysts think highly of the fund and expect it to outperform over a full market cycle of at least five years," including the possibility of outperforming a relevant benchmark. There are also Neutral and Negative ratings for lower-rated funds.

Enough time has now passed to get a sense of whether these new Morningstar ratings for funds, introduced with a great deal of fanfare at the end of 2011, are indeed doing what they claim: To help investors pick what will prove to be the best performing stock funds in the future (as was likely intended to be the case with the star ratings), as compared with those within the same specific fund category. Investors need an answer as to whether is it now a valid assumption to expect these newer ratings to be able to do any better than the old system of star ratings that Morningstar continues to display prominently with the Analyst ratings.

While Morningstar derived its Analyst and star ratings from a comparison of funds within each rated fund's category, such as, for example, Large Growth or Foreign Small/Mid Value, to its peer group, I counted 17 different stock fund categories included in the initial list of Analyst ratings and 12 different Foreign and World stock funds. (Note: To see the initial list of Analyst Ratings, click here.) Obviously, most investors are not able to own anywhere near this number of funds. Therefore, they highly likely can get the most value merely by looking at the ratings as measures of overall fund favorability as compared to ownership of a broad stock index fund.

For Large Cap stock funds, one of the most relevant such funds would be Vanguard 500 Index Fund (VFINX); for Foreign funds (excluding those that contain a mixture of US and non-US stocks), the most relevant fund might be Vanguard Total International Stock Index Fund (VGTSX). In other words, the question that likely may be the most important for fund investors seeking some general guidance in picking a portfolio with a limited number of funds becomes: Do the most highly rated funds tend to outperform these index funds, regardless of the performance of the multitude of Morningstar stock fund categories? And do the 5 possible ratings for Analyst and star ratings, from highest to lowest, help to predict the best vs. the worst performers?

In a video and accompanying transcript posted in late 2016 entitled "A 5-Year Report Card for the Morningstar Fund Analyst Rating," Morningstar's Director of Fund Research reiterates that a 2011 fund rating, as a present one, looks "out over the next five to 10 years to see how we think it will do against peers and benchmark." But he only mentions a handful of the approximately 350 funds initially rated, citing a few successful ratings and some not so successful. It is relatively easy to see that this is hardly a meaningful analysis since it omits telling us about the overall usefulness of the entire set of rated funds, or even a significant subset.

Unfortunately for investors who would like to rely on either of these types of ratings to pick the best subsequent performers, the data I will now present fails, for the most part, to show that after 5 full years for two of perhaps the most important fund subsets, that ratings were significantly helpful for investors who might have expected the most highly rated funds to outperform these index funds or even the lower such rated funds. Even if just the highest rated funds cannot do better than the lowest rated funds, this suggests a serious problem for the rating system.

Here is a brief summary of the average 5 year annualized performance results from Jan. 2012 through Dec. 2016, for all the managed US Large Cap, and separately, managed Foreign stock funds (i.e., both exclude index funds) that were originally rated using the new Analyst system rolled out in late 2011:

US Large Cap Fund Performance Sorted by Analyst Rating

Contrary to Morningstar's overall premise that the highest rated funds would outperform, the funds that were rated Neutral and Negative did better than the "medalists" and were the only ones, on average, to do better than the benchmark index fund. And, the lowest category of medalist, Bronze, actually outperformed the two higher rated ones.

One might correctly say that predictions went nearly exactly the opposite as Morningstar ratings would have predicted.

Foreign Fund Performance Sorted by Analyst Rating

The Gold Foreign stock funds did perform better than the two other medalist categories and better than the benchmark index as Morningstar would have predicted. Note, though, that the average performance difference between the Silver and Bronze funds was quite small and neither rating category did better than the benchmark index which, if the reverse were true, would have been a major reason why one would have preferred one of these medalists over merely choosing an index. However, the relatively small number of Neutral rated funds performed best of all, and considerably better than the Silver and Bronze funds. The small number of Negative rated funds did perform poorly, consistent with Morningstar's low rating.

One might say, then, that the Analyst ratings for Foreign funds were generally successful, although with each of the four individual Neutral funds doing considerably better than the benchmark as well as the average return for the Silver and Bronze medalists, it is suggested that, as with US Large Cap ratings above, Neutral rated funds, seem to do far better than expected.

Fund Performance Sorted by Star Rating

The same funds as above had star ratings available when the Analyst Ratings were given. One might ask how the star ratings did over the same five year period.

Here is a brief summary of the average 5 year annualized performance results from Jan. 2012 through Dec. 2016.

US Large Cap Funds

The funds that received 5 stars were, on average, the worst performers by a very large margin, and the limited number of funds with 1 star, the best performers, although by an insignificant margin. Likewise, funds with 2 stars did better than those with 3 stars, also by a small margin. It would appear, then, that anyone expecting funds with the highest number of stars (5 or 4) to do measurably better than a benchmark index fund, or, the funds with the lowest number (1, 2, or 3) would have had their hopes dashed, especially by the 5 star funds where nearly the exact opposite occurred.

Foreign Stock Funds

Here, the average fund with a medalist rating tended to do well and better than the index fund, although the funds with 3 stars did better than the ones with 4 stars. It would be impossible to offer an opinion, without more data, as to why the single 1 star fund did better than the average performance for most of the higher rated funds.

This Data Suggests Morningstar Ratings Have Limited Usefulness

In spite of Morningstar's above-referenced statement that its more recently developed Analyst Ratings can "provide forward-looking perspective into a fund's abilities," (i.e. performance potential), if we look at the ratings' usefulness in predicting 5 year average annual total returns starting shortly after the introduction of these ratings, little evidence can be seen that would appear to justify, at least thus far, using the ratings to help get its readership get better future performance results. This result is particularly true for the 64 Large Cap stock funds that were initially rated in late 2011, although somewhat less true for 33 Foreign funds that were part of those selections.

The fact that Neutral and Negative Analyst rated US Large Cap stock funds did better on average than the medalist funds in nearly an inverse way to that which would have been predicted by the Morningstar system suggests to me that funds that seem excellent based on prior performance and other known factors should often be viewed more aptly only as excessively good appearing funds. But, as this data seems to suggest, good appearing may not be any more reliable a predictor of future performance than past performance. And in the fund investing world, such funds can sometimes tend to have a hard time maintaining such a standard of excellence. Therefore, fund investors might well be better off being leery of funds that seem to be too high on a pedestal.

Even an organization such as Morningstar that most likely provides the most effort with the most analysts in attempting to predict which will be the most successful funds going forward, has been shown to have a great deal of difficulty in accurately accomplishing that task. Therefore, investors may want to question the ultimate value of placing much confidence in such information. As always, low expense ratios, along with generally good and relatively consistent performance (but not so good as to suggest a possible inability for a repeat performance) achieved by ongoing long-term managers at well-established fund companies, are among the best indicators that can be used to try to identify future outperformance.

Bottom line: Investors should beware of using any as of yet unproven ratings of funds as their guide to attempting to select those funds with the best future performance potential.

Author's Opinion but Not a Substantiated Fact

So does the above data also suggest that you should mainly choose index funds instead of looking for even the best Morningstar regarded managed funds? Perhaps, but consider this: Both VFINX and VGTSX currently have Gold Analyst Ratings from Morningstar, as do other well-regarded Vanguard index funds such as Vanguard Small Cap Index (NAESX) and Vanguard FTSE All-World ex-US Index (VFWIX).

If managed Gold rated funds in the past have not necessarily proven to be the best performers going forward, the same may turn out to be true (at least at this time) regarding what I consider to be excessively good appearing index funds. While the fundamentals that Morningstar rates in arriving at their Analyst Ratings for these index funds will likely remain excellent in many respects, on the other hand, since an index fund lacks a true manager, if the index turns out to be overvalued, not having a skilled manager who can potentially avoid blatant excesses will likely prove to be such a fund's Achilles heel.

---

To sign up to receive notification of new Newsletter postings as well as infrequent, but crucial, investment Alerts, click here.

---

If you find this month's Newsletter helpful, consider pasting this link to it in an email to a friend:
            http://funds-newsletter.com/sept17-newsletter/sept17.htm