Too often, investors look at the Morningstar “star” system to pick mutual funds. If the fund has five stars, the investor picks it and moves on. This is a flawed approach in many ways. The Morningstar system is too short term. A manger who has one or two good years gets a high ranking, but that ranking could be due to one or two risky positions that happened to pay off. The opposite holds true as well.
I have always argued that the biggest factor is your expense ratio, which is why I don’t typically use mutual funds. I prefer index funds or Exchange Traded Funds (ETF). In fact, I only use one actively managed fund right now, and that is for international bonds. I will detail my reason in a future post this week.
As it turns out, picking a fund based on expense ratio proves to be a better process than by using the Morningstar star system. This study should be trusted as it comes from Morningstar itself. Here is a summary of how Morningstar looked at the data:
We took a snapshot of star ratings and expense ratios from 2005 through 2008 and then tracked their progress through March 2010. We rolled up category level data into five broad asset classes: domestic equity, international equity, balanced, taxable bond, and municipal bond.We then measured total returns as of the end of March 2010 for the mutual funds that survived the entire period. For the success ratio, we included funds that were merged or liquidated, as well as those that survived, in order to calculate the number that both survived and outperformed. For the star rating, we recorded the five-year star rating for the data set from 2005, as well as the three-year rating. For 2006 and 2007, we recorded the ensuing three-year rating–meaning we measured the figure in March 2009 for the class of 2006 and the rating in March 2010 for the class of 2007. For the class of 2008, we don’t yet have a star rating.
Here is what they found:
If there’s anything in the whole world of mutual funds that you can take to the bank, it’s that expense ratios help you make a better decision. In every single time period and data point tested, low-cost funds beat high-cost funds.Expense ratios are strong predictors of performance. In every asset class over every time period, the cheapest quintile produced higher total returns than the most expensive quintile.
For example, the cheapest quintile from 2005 in domestic equity returned an annualized 3.35% versus 2.02% for the most expensive quintile over the ensuing five years. The gap was similar in other categories such as taxable bond, where cheap funds returned 5.11% versus 3.82% for pricey funds. That same relationship held up dependably in the other time periods we measured. For 2008, the cheapest quintile of balanced funds lost 0.04% over the next two years, while the most expensive shed 1.13%.
This is impressive data in favor of low cost funds, but what is probably a blow to Morningstar’s ego is the following data:
In 2005, 5-star domestic-equity funds produced a subsequent return of 2.8% versus 1.6% for 1-star funds. Balanced funds and municipal-bond funds enjoyed a slight edge, but 5-star international funds that survived actually lagged the returns of 1-star funds that survived.
Bottom line according to Morningstar:
The expense ratio and the star rating helped investors make better decisions. The star rating and expense ratios were pretty even on the success ratio–the closest thing to a bottom line. By and large, the star ratings from 2005 and 2008 beat expense ratios while expense ratios produced the best success ratios in 2006 and 2007. Overall, expense ratios outdid stars in 23 out of 40 (58%) observations.
Perhaps the most compelling argument for expenses is that they worked every time–because costs always are deducted from returns regardless of the market environment. The star rating, as a reflection of past risk-adjusted performance, is more time-period dependent. When the market swings dramatically, the star rating is going to be less effective.
So the next time a broker hypes a fund by showing you the number of stars, just ask them if it is the lowest cost fund for that asset class. If the broker asks why, tell them about this report. That should put him or her on alert.