Don’t Get Starry-Eyed—It’s the Gold That Counts at Morningstar

03/25/2013 10:30 am EST

Focus: FUNDS

Investors can get too caught up in Morningstar’s star ratings, forgetting that those ratings focus only on the quantitative, says Richard Loth of The Fund Investor's Schoolhouse.

The investing public tends to neglect doing its evaluative homework and chooses funds based solely on Morningstar’s star-rating system. It’s quick and easy, but that doesn’t mean it’s necessarily the best way to pick a fund.

While useful and easy to understand, the fund star ratings provided by Morningstar —ranging from one to five (lowest to highest)—have their limitations. They should not be looked at as the primary criteria for selecting a mutual fund.

Morningstar doesn’t disagree with this assessment, and has regularly told its readers so, but too many fund investors aren’t getting the message.

Here’s the problem. The star ratings are purely quantitative; they don’t pick up critical evaluative criteria; and they are backward looking. Morningstar openly states that “the star rating system is a report card, not an aptitude test.”

While it’s nice to see a mutual fund with four or five stars from Morningstar, I have a better suggestion for selecting funds, and, ironically, it’s Morningstar to the rescue.

In the US, the mutual-fund universe has around 8,000 funds for investors to choose from. Most financial experts agree that a few hundred funds would be more than adequate to address the needs of the investing public.

This circumstance certainly sends a clear cautionary message to investors: the mutual-fund industry is a highly profitable business. Caveat emptor.

Morningstar’s state-of-the-art investment research covers some 2,300 funds. I recommend that if a fund does not have Morningstar analytical coverage, it isn’t even worth considering. Obviously, this still leaves plenty of funds to choose from, so why bother with those that have little or no independent, reliable information on which to base an informed investment decision?

This is not to say that Morningstar is infallible. However, the breadth and depth of its mutual-fund evaluations set a very high analytical standard that is unmatched in the investment research industry.

Morningstar makes life really easy for fund investors by paring down its fund analytical coverage to special groupings that carry its recently formulated (November 2011) “Analyst Rating” designations—Gold, Silver, Bronze, Neutral, and Negative.

An Analyst Rating reflects a synthesis of five aspects—Morningstar uses the term “pillars”—of each fund’s fundamental strengths and weaknesses. These items break down as follows:

  • People: Morningstar talks to fund managers, analysts, chief investment officers, and visits fund companies on a regular basis. Expertise, experience, tenure, and demonstrated skills are evaluated.
  • Process: The competitive advantages of a fund’s strategies are analyzed. How well is the strategy matched to the manager’s and firm’s skill set?
  • Parent: How strong is the fund company? Manager depth and turnover, the investment culture, quality of research, ethics, directors, and regulatory compliance are all examined.
  • Performance: A long-term record is more predictive of future relative performance. How a fund has performed in different market environments, its risk profile, and consistency of returns are important.
  • Price: Costs have been a good predictor of fund performance.

Currently, there are some 193 mutual funds that Morningstar classifies as “Gold,” which it considers to be the equivalent of the “best-in-class” funds. Thoughtful selections of funds from this elite pool are worth holding for the long haul.

It is interesting to note that a majority of the Gold-rated funds do not have a five-star rating, and, in fact, a large number carry only two- and three-star ratings.

So, I would strongly recommend following Perry Como’s suggestion and kick the Morningstar “star habit.” Focus your fund research on its Gold analyst rated recommendations for investing in high-quality mutual funds.

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