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The Star Rating Performs Well but Our Picks Are Better

Our annual update shows the star rating and picks keep chugging along.

Russel Kinnel, 01/06/2009

This article originally appeared in Morningstar FundInvestor, an award-winning newsletter that presents investment strategies and tracks 500 funds.

In our latest evaluation of the Morningstar Rating for funds, we find that it continues to be modestly successful in forecasting performance.

The star-rating methodology was reconstituted in the summer of 2002, and each year since then we have produced a study examining total returns, relative performance, and risk-adjusted performance at the end of June. Then we look at how it did at predicting those factors over the ensuing years so that we can understand how investors using the rating to aid their decisions would have fared.

How the Rating Works
It's important to note that the star rating is a purely quantitative measure, updated every month, that's based upon past returns and volatility. Specifically, it measures load-adjusted total returns from the past three-, five-, and 10-year periods. Then it adjusts for risk so that high-risk funds are taken down a peg or two, and low-risk funds are moved up a bit. The risk-adjusted measure is then graded on a curve within a category. We give 5 stars to 10% of the funds, 22.5% earn 4 stars, 35% take the 3-star rating, 22.5% take 2 stars, and 10% earn 1 star.

You'll notice many important things aren't included in the rating, such as our analysts' opinion, the manager's record, and expense ratios. The rating is a handy measure of past risk-adjusted performance, but it is not a recommendation and it certainly is not the whole story. Rather, it's a handy way to narrow your search for a fund and a way to keep tabs on the funds you own. The data in our study show why.

How the Rating Performed
In the aggregate, 5-star funds beat 4-star funds, and 4 beat 3, and so on. (See the related table.) This is true of returns, ensuing star ratings, and batting average. For example, using ratings of domestic-equity funds from 2003, 5-star funds returned an average of 9.90% annualized over the next five years compared with 9.20% for 4-star funds, 9.04% for 3-star funds, 9.22% for 2-star funds, and 8.70% for 1-star funds. The gap between each star rating group is hardly the Grand Canyon, but by the time you get out to 1-star funds, which lag the 5-star group by 120 basis points per year, that's a pretty big deal. The gap for the class of 2003 was smallest for international equity (63 basis points) and largest for balanced (313 basis points).

For 5-year star ratings over the next five years, 5-star funds earned an average of 3.07 stars compared with 2.73 for 1-star funds--again a modest differential.

The same is true for batting averages--a measure of what percent of funds beat their peer group averages, though in our example of domestic-equity ratings from 2003, there was a surprise. We saw 54% of 5-star funds beat their peers over the next five years. That figure declined to 42% for 3-star funds, but then picked up slightly for 2-star funds to 44%, and 1-star funds had a nifty 53% batting average. What happened? Extinction. Many 1- and 2-star funds were liquidated over the five years so they didn't show up to bring the batting average down. However, if you instead ask what percentage of funds survived and beat their peer group, the figures make more sense: 49% of 5-star funds met that hurdle, while 43% of 4-star funds did, down to 33%, 30%, and 36% for the bottom three rating groups.

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