Money Matters: Don't overemphasize the Morningstar rating

By Ashley Wilson The Daily Record Newswire The Morningstar rating, used for years by investors and financial advisers to select funds, may lead people astray if it is the only criteria used when trying to construct a solid investment portfolio. This well-known rating approval (or disapproval) for mutual funds is essentially based on past performance, relative to peers, with an adjustment for risk. It may have some value in choosing funds, but not to the extent that most investors think. Many studies have arrived at generally the same conclusion - funds with four-star and five-star ratings often don't perform any better than others three, five and 10 years down the road. The reason is that past performance doesn't tell the whole story. Future performance is most important. So, when selecting mutual funds, don't use only the Morningstar rating, but consider other fund attributes, like turnover, manager tenure, high-risk behavior and expenses. Portfolio turnover is important because it's an indication of the amount of trading by a portfolio manager. If turnover is 50 percent, then half of the stocks or bonds that were in the portfolio at the beginning of the year are now gone. High turnover in equity funds may indicate higher fees and poor performance over the long term, because the portfolio manager may be trying to time the market and incurring a lot of transaction costs to do so. Turnover exceeding 100 percent in an equity fund can be a red flag, depending on the fund's strategy. Manager tenure is rarely considered, but important when selecting a mutual fund. If a portfolio manager has managed the fund for five, 10 or 20 years, and performance of the fund has been stellar in that time, then luck is probably not the only factor. This manager most likely has talent and knows how to pick good investments, especially if the fund has performed consistently for a long period of time. Remember that for a fund performing poorly, the manager's job security is at stake. A replacement could manage the fund a lot differently, and that could be a good thing or a bad thing. High-risk behavior can be difficult to uncover in a mutual fund, but one indication is the use of short positions. Shorting is a strategy that profits from an investment's decline. Most commonly, bets are made against currencies like the dollar or against individual stocks. The potential loss in this type of strategy could be unlimited, so it introduces an additional layer of risk that can be significant. Also, there is a real lack of transparency in mutual funds, so one often doesn't know exactly what the manager is shorting or the strategy being used. In addition, fund expenses must be reasonable. I define this as industry average or lower. This will vary based on what share class it is (i.e., how expenses are paid by the investor) and what kind of a fund it is. Generally, international stock funds have higher expenses than U.S. stocks funds, and U.S. stock funds have higher expenses than bond funds. Consider adding funds to a portfolio only if the fund expenses are reasonable, given the fund's share class and category. I just finished up an analysis of 624 funds that are offered through a particular 401(k) provider. These are some of the most widely held funds in existence. When working with a business owner or an investment committee, I need to narrow these 624 funds down to 20 that will make up their 401(k) offerings. That may sound difficult, but I really need to choose from only about 60 of them. If performance metrics are applied, along with turnover, tenure and expenses, only 10 percent of some of the most widely held funds in existence pass the test. One of the worst funds of the 624 has high turnover, uses short positions, has a manager who has been there less than a year, and has fund expenses well above the industry average. For this fund, increasing trade activity is driving costs up. Higher costs make it more difficult for the portfolio manager to compete with peers who have lower costs. A manager of a fund not performing well may take on more risk or trade more to try to improve results. Such attempts often backfire and drive performance down even more. Use a variety of criteria to track funds over time. Performance changes daily and is the result of many other characteristics, such as expenses, manager tenure, behavior and turnover. As part of the process, an investor should obtain and read a prospectus from a financial adviser or the fund company and carefully consider the investment objective, risks, charges and expenses before investing. The return and the principal value of an investment will fluctuate, so an investor's shares, when redeemed, may be worth more or less than original cost. An investor who is able to evaluate funds beyond performance won't be as tempted to bail from a fund because of a short span of underperformance; or worse, investing in a new fund after reading about it as a must-own. A study by DALBAR Inc. points to the negative consequences of chasing performance. During the 20-year period ending in 2008, it looked at various average returns in different asset classes, like the S&P 500, REITs, bonds, homes, international stocks, gold and oil. It also tracked the performance of the average equity investor, who placed last with an annualized return of 1.9 percent. "Joe Investor" couldn't even beat inflation, which came in at 2.8 percent a year. If investors keep making the same mistakes of judging investments solely on past performance without considering future potential, they may be forever doomed to underperform and make poor decisions. ---------- Ashley Wilson is a financial adviser with the Wilson Financial Group of Stifel, Nicolaus & Co. Inc. in Portland. Contact her at 503-499-6260 or wilsonam@stifel.com. Published: Thu, Jun 2, 2011