Do Not Blindly Follow the Stars!

Do you ever use Morningstar to research and select funds for your portfolio? If so, you’re not alone. Morningstar is the undisputed leader in providing investors with valuable information about the returns, risks and costs of mutual funds.

So, how do you select a fund? Most investors naturally gravitate to the funds that have a 4 or 5 star rating. They know these funds have done well in the past or they would not have received one of Morningstar’s higher star ratings. Investors figure if a fund has done well in the past, it is likely to perform well in the future.

Is this true? Advisor Perspectives, an e-newsletter, recently published a study suggesting that these star ratings have little predictive value. In fact, the research indicates that 5 star funds are likely to underperform their peers. According to Morgan Stanley Smith Barney’s Consulting Group, the top 10% managers can repeat their success. But, the study also points out, the worst 20% of performers are also likely to outperform in the future.

These findings are consistent with the concept of “reversion to the mean.” This is the theory that performance eventually moves back toward the mean or average. If this is valid, an investor could actually pursue a strategy which entailed investing in funds that have not performed well recently. The expectation would be that these funds, assuming there were no clear reasons for their underperformance, would eventually outperform as they moved back to the mean.

We do know this for certain. Past performance does not guarantee future results. Be careful about relying on the stars to reach your investing destination.