How to Avoid 5-Star Duds
A high star rating is no guarantee of a good mutual fund.
The Morningstar Rating for funds, better known as the star rating, has always been one of our best-known and most popular features. However, it's important to recognize what the star rating can and can't do. We designed it as a concise way to measure a fund's risk-adjusted past returns against its peers, and on that count it does a very good job, especially since we improved the methodology a few years ago. But past performance is no guarantee of future results, and the star rating is not meant as a way to predict which funds will do well going forward.
While it's true that highly rated funds tend to do somewhat better going forward than low-rated funds, as we found in a preliminary study, we always advise investors to go beyond the star rating. Screening for funds with 4 or 5 stars is a reasonable way to start winnowing down the fund universe to a more manageable group, but it also pays to look beyond the star rating and do more fundamental research. Here are a few ways to watch for funds whose star rating might not tell the whole story and to find hidden gems that might be overlooked by star-struck investors.
Beware of Manager Changes
One important limitation of the star rating is that it doesn't take into account manager changes or other significant changes in how the fund is run. If a fund has been in existence for 10 years, its star rating will incorporate that whole time frame, even if most of that performance was under a manager who's no longer around. That's why it's always a good idea to check highly rated funds to see how long the current management team has been in place, because a rookie manager will tend to make such funds less attractive than they might appear at first glance.
David Kathman does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.