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Tuesday, April 3, 2012
The practice is alive in the mutual fund industry. Morningstar will give your mutual fund 1 star even if its performance came in the bottom 10% of its peer group. You get 2 stars if you came in the bottom third. Mrs. Zitnay would be proud. I doubt the participants in those funds are clapping though.
I'm starstruck this morning because last night I read my copy of Financial Planning magazine and every other page is peppered with advertisements for mutual funds, most of which have 4 or 5 Morningstar stars. Unless you're a Taliban warlord hunkered down in the mountains of Afghanistan, you've seen these ads. They are in most major magazines.
What do they tell us? Are these the funds we should be investing in? Does the evidence show that having 5 stars predicts strong future performance? What is the relationship between Morningstar and the fund companies? How come when I go to a fund site I see the predominance of funds have 4 and 5 stars? Are they all producing superior performance? When I see a claim that 8 funds out of 30 received 5 stars, does that mean the 10-year period started with 30 funds or are those that bit the dust from poor performance not included?
Actually, there is evidence on these questions. Numerous studies over various periods show that superior performance in one period does not tend to be followed by better than average performance in subsequent periods, when all costs are taken into account. In fact, Morningstar itself has produced studies showing that costs are a better predictor of future performance than their star system! Guess what? There is no mention of costs in the ads! And for good reason, but that's been the subject of other posts.
Please allow me a short side rant for a moment on the whole star business. The global economy has just come through a period in which it was brought to its knees by misleading ratings on packaged mortgage securities by the major rating industries. At the time, bankers and investment banks looked the other way as rating industries gave the highest possible ratings to securities that were comprised of bankrupt payees. The reason was simple - in the short run, the high ratings generated billions in fees as the securities were bought by naive investors.
Here now we have stars jumping out at us with the explanation of the Morningstar star system in small print footnotes that most people would have a hard time deciphering. The message that the funds are superior investment vehicles jumps out at the magazine reader. The evidence shows that individuals, as well as even administrators who choose mutual fund providers for 401(k) plans, are misled by these ratings. But again it's about big bucks.
Down the road, as baby boomers retire and their nest eggs have been eaten up by high-priced 4 and 5 star funds, everyone will act as if they don't know what happened. And again Wall Street will walk away with the big bucks.