As with all quantitative systems, a few dogs will slip through the cracks.
I've written how early tests of the Morningstar Rating for funds indicate it has some value in predicting future performance. However, I'm always careful to point out that it's simply a quantitative measure of risk-adjusted performance and, therefore, does not serve as a substitute for fundamental research. As with any measurement of risk-adjusted performance, including the Sharpe ratio and alpha, there are cases where the fund isn't as good as the performance measure would lead you to believe.
To illustrate those limitations, let's look at some 5-star funds that really aren't as attractive as they seem at first. The biggest limitation of the star rating is that it doesn't incorporate changes to a fund's fundamentals, such as a change in managers or strategies. Even when it comes to reflecting performance, the star rating can miss a thing or two. The star rating rolls up three-, five-, and 10-year returns, but that means that a nine-year-old fund's record from years six through nine won't be reflected in its star rating. In addition, if a fund invests in a super-hot asset class, big returns can mask risks enough so that high-cost, high-risk funds can still win 5 stars. That doesn't happen often, though. Only 58 of the 448 5-star funds (using distinct portfolios only) have expense ratios that are above their category averages.
Here are some examples of funds whose star ratings are a lot better than they are.
This fund is a classic example of the quirkiness caused by the time periods that factor into the star rating. Investors who bought at inception are still about 70% in the hole, yet this fund still has 5 stars because its horrific bear-market losses are starting to roll off the five-year record. The fund's 79% loss in 2000 isn't there, and its 56% loss in 2001 is starting to fade.
Needless to say, this is a bad investment. It has high expenses of 2.64%, poor long-term returns, and an unimpressive manager. I was shocked to see a major business magazine include this fund on its list of the best ways to bet on the second wave of Internet stocks.
Rydex Midcap Advantage
This fund aims to deliver 150% of the beta of the S&P 400. Because mid-caps have been a sweet spot for the market of late, the fund has nifty returns that earn it 5 stars. But this is probably the worst time to buy the fund. The stocks it favors have had a nice run, so that means its risk has gone up. History shows that even a middling market can be murder on a leveraged fund. See Rydex Nova's