Fund Flows Not Always Written in the Stars

Mike Rawson: Investors tend to put their money in funds that have had good performance. So when we look at fund flows by star rating, we see that the 4- and 5-star funds attract a lot of assets, while there are actually outflows from 1- and 2-star funds.

It's important to remember that the star rating is a past risk-adjusted measure of performance. It's not an opinion about how well the fund is going to do in the future. This pattern of investors choosing funds that have had good recent performance, it really indicates a couple of things. First of all, it indicates that investors maybe have an easier time buying into a fund that has had good performance. If you're going to a financial advisor, it might be easier for him to sell a fund that has had good performance. That's the downside. The positive side is that funds that have had good past performance tend to be lower-cost. So investors may also be picking funds that have low costs, and those low-cost funds are more likely to have good performance in the future.

Another noticeable feature about fund flows is that funds that do not yet have a star rating actually received the strongest flows overall. These are funds which have not been around for three years, so we can't yet assign a star rating to them. So it's important to remember that if a fund doesn't have a track record that often it's those funds that have poor performance, the 1- and 2-star-rated funds, which are shut down and may be replaced by a new fund. So when assessing funds to invest in, investors should try to understand why a fund maybe does not have a star rating. If it's a new fund, these are the kind of funds which are often heavily marketed toward investors.

It's important to remember that the star rating is just one measure of performance. There are other metrics that investors should analyze before picking a fund. 4- and 5-star funds have had good past performance, but that's no guarantee that they are going to have good performance in the future. Meanwhile, a fund that does not yet have a star rating basically means that the fund has not been around for three years, so it has not yet had a performance track record on which to judge it.