Review & Outlook

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Why “Five Star” Mutual Funds Don’t Last

10 September, 2014 by Ben O'Brien in Commentary

There are lots of reasons why we don’t invest in mutual funds. The Wall Street Journal recently reported on one: the over-emphasis on past performance.

Past performance does not necessarily predict future results. The SEC requires this disclaimer to be plastered all over investment advertising. And it is true. And yet, in the $15 trillion U.S. mutual fund market, many investors rely primarily on Morningstar’s star ratings that are based mainly on past performance. The Wall Street Journal recently reported that five star ratings tend not to hold up over time just as the SEC disclaimer warns:

Morningstar, at the request of The Wall Street Journal, produced such a list of the top-rated stock and bond funds and what has become of them. Analysts at the investment-research company found the vast majority of the biggest five-star funds from five and 10 years ago no longer have a top rating.

For investors, it isn’t necessarily terrible if their fund drops a notch; of funds that had a five-star overall rating as of July 2004, 37% had lost one star 10 years later. But 31% lost two stars, 14% dropped three, and 3% lost four. Two of the top-rated funds from 10 years ago, Columbia Marsico International Opportunities Fund and Fairholme Fund, went from having five stars for July 2004 to having just one star and two, respectively, for July 2014. Only 58, or 14%, of the 403 funds that had five stars in July 2004 carried the same rating through July 2014, Morningstar says.

Part of the reason for the lack of long term outperformance among highly rated funds in the boom and bust cycle that mutual funds tend to follow.

First a fund has good performance and attracts a lot of publicity and high ratings. Then comes a huge influx of new assets for the fund to manage. The manager must suddenly find a good place to invest all of this new cash. Faced with this pressure, the fund tends to stumble and performance lags just as all the new investors come aboard. As a result of this cycle the returns of mutual fund investors tends to be a lot worse than the performance of the funds themselves. Investors tend to get in and out at the wrong time.

Morningstar responded to this criticism in recent years by adding a new rating system to the mix that focuses more on the future outlook. But the stars remain influential and the added level of ratings may only confuse matters for many investors.

The emphasis on past performance and the boom and bust cycle are good reasons to avoid mutual funds. At O’Brien Greene we prefer to build portfolios mainly of individual stocks and bonds invested for the long run.