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Should You Look for a Five-Star Fund?

October 2010

Picking Stocks

Should you put your money in a five-star mutual fund? A study by Christopher Blake (Fordham University School of Business) and Matthew Morey (Smith College Department of Economics) indicates that funds that boast Morningstar’s top five-star ranking garner 90 percent or more of the new money flowing into funds.

Alas, as Blake and Morey and others show, all these investors are really doing is betting that a money manager’s recent run of good luck will continue. Nathan Hale who blogs at Moneywatch puts it this way: “[L]et’s say we gather 1,000 fund managers in a room, and ask each of them to flip a coin. If they flip heads, they remain standing and flip again; flip tails, they sit down. And after ten flips, only one will [still be standing]. Should we crown this manager king of all coin flippers, believing that he’s somehow divined a method of coin-flipping that will produce heads consistently? Of course not. He was simply lucky.”

Morningstar and Standard & Poor’s have created multimillion dollar businesses by ranking mutual funds based on past performance, giving four- and five-star rankings to funds that have had the best “performance” over the last year. Nearly every retirement plan in the US includes data on each mutual fund’s recent “total returns” (annual price gains plus dividends). This data is supposed to help participants select the right investments. But a recent study from Standard and Poor’s confirms that past performance is nearly useless as a guide to mutual fund selection.

Looking at fund performance from 2005 to 2009, only 4.27 percent large company stock funds, 3.98 percent mid-sized company funds, and 9.13 percent small company stock funds were actually able to maintain a top-half ranking over the five consecutive years. No large- or mid-cap funds, and only one small-cap fund maintained a top quartile ranking for the whole five-year period from 2004 to 2009.

Looking at ten year data, the study showed that 24.32 percent of large company funds with a performance that put them in the top quarter from 1999 to 2004 stayed in the top-quarter over the next five years. Only 16.39 percent of mid-sized company funds and 27.06 percent of small company funds repeated their top-quartile performance. You might think, “Well that proves that at least those funds really did have better managers!” But in fact, random expectations would suggest a repeat rate of 25 percent, meaning that the winning funds’ performance was just as likely to be due to luck as to skill.

S&P’s research suggests that screening for top-quartile funds is counterproductive in another way: a healthy plurality of future top-quartile funds comes from the prior period’s second, third and even fourth quartiles, while plenty of top ranked funds found their way to the bottom of the list in the following period. Screening out bottom quartile funds (one star funds) probably makes sense, though, since these duds have a very high probability of being merged or liquidated.

So how should you pick funds? One of the only common threads among the most successful funds in the S&P study was low cost. By choosing the lowest cost funds you may not always be first, but at least you’ll get to keep more of the dividend and interest income and more of whatever gains the markets give you. So, the best bet is to pick the cheapest fund (the no-load fund with the lowest expense ratio) available to you in each of the major investment categories.

At Responsible Investing, we can help you learn how to master key money management skills and make well-reasoned choices between different investment options. To learn more about our affordable classes and independent advisory and coaching services click here.

Responsible Investing is an independent financial coaching and investment advisory firm, registered with the Commonwealth of Massachusetts.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Past results are not indicative of future performance. Outside sources used in this article are believed but not guaranteed to be accurate. Examples provided are for illustrative purposes only and are not representative of intended results that a client should expect to achieve.