Your Funds: ‘Wishing on stars’ is now an okay investment strategy

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For decades, mutual fund investors were told not to go wishing on stars when it came to selecting investments.

Individuals mostly ignored that advice, however; virtually all money flowing into mutual funds for nearly 40 years has gone into issues that earn 5- and 4-star ratings from Morningstar Inc., the Chicago-based research firm whose data is ubiquitous in the mutual fund and ETF world.

From the beginning in 1984, Morningstar officials said star ratings were not predictive, telling you only which funds had done well relative to the risks they took on and the competition they faced. Looking back at results, they didn’t do a great job forecasting the future.

The firm spent decades refining its system. It developed analyst ratings to give funds gold-silver-bronze judgments, and quantitative ratings that use the same medalist scale; both are forward-looking, trying to spot funds that can outperform in the future. But now it turns out that the simple star rating has been pretty effective in spotting winners.

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I was reminded of that last week not only because Morningstar recently released results of an analysis of its rating systems, but because my oldest daughter started a new job and called for help picking investments in her new retirement plan.

At 31, she is money-savvy and a good saver, but not well-versed at picking mutual funds. Her 800-mile move to a new teaching job that started recently left her with barely a minute to dive into her benefits package. But she said magical words that would thrill any parent, “I’m going to max out my 401(k) contributions.”

She noted that the retirement plan’s default choice would be an age-appropriate target-date fund that she knew nothing about “except that it gets five stars; is that good enough?”

It turns out that it is. While she may want to take more control of her 401(k) investments in time, being in a five-star life-cycle fund from a solid, name-brand firm is a great start. All she needed to know to be comfortable was the star rating.

Of course, that’s what investors have relied on for years, even as Morningstar analysts protested such behavior.

Some of those arguments stemmed from methodology that has changed. It was never hard to find Morningstar analysts who suggested buying funds with low ratings or selling ones that get higher marks, but that was a tough sell to the investing public, which wanted the ratings to be decision-makers rather than helpers.

The star system itself was meant to be objective. Based on risk-adjusted returns within a fund’s peer group, stars are awarded on a curve, so the top 10% of a category gets five stars, the next 22% earns four stars, the middle 36% receives three stars, and so on. Investors treated stars as an endorsement of which funds were likely to perform best. “Best” might be a stretch, but “good” isn’t. Thus, for people hoping for the “best,” the idea has become “stars plus.”

Since the fund introduced analyst ratings in 2011, there’s no denying that funds earning top star and analyst ratings were money magnets; as one financial adviser has told me for over a decade now, “No investor rejects the idea of adding a five-star, gold-medal fund to their portfolio.”

The Morningstar self-examination suggests that thinking has paid off. Yes, it feels a bit self-congratulatory, but there’s not much arguing with its conclusions.

Higher-rated funds were two or three times more likely to survive and outperform in the future than lower-rated funds; 1- and 2-star funds were likelier to lag their peers or go out of business. Top-rated funds still struggle to beat benchmark indexes but were roughly four times more likely to retain a top rating after 10 years than a one-star fund looking for a turnaround.

As much as investors love stories of unloved investments where managers overcome the odds and make a grand comeback, those tales are statistically rare. Empirically, even when a manager turns performance around, the ride is often so rough that investors struggle.

Consider Auer Growth fund (AUERX), where manager Bob Auer once said during a rough patch that the fund “was lucky to get even one star from Morningstar.” In the last 10 calendar years, the fund has been in the top 10% of its peer group three times, top 20% once and the bottom 10% six times. Thanks to great results in 2021 and thus far this year, the fund now carries a four-star rating, but you’d be hard-pressed to find any fund analyst — from Morningstar or elsewhere — in love with a high-cost, feast-or-famine performer.

Jeff Ptak, chief ratings officer at Morningstar, said changes to the ratings and the industry have made for more apples-to-apples comparisons in mutual funds and ETFs. The more that investors want the things that the Morningstar system tends to focus on, the more dialed in the ratings become. Investors wishing on stars has, in turn, made the stars more worth wishing on than ever before.

There’s no guarantee that it stays that way, but after decades of warning investors to avoid over-reliance on ratings, it’s a big change to say that despite skeptics and the outliers that are exceptions to any system, there’s much more to star ratings than blind hope.

Chuck Jaffe is a nationally syndicated financial columnist and the host of “Money Life with Chuck Jaffe.” You can reach him at itschuckjaffe@gmail.com and tune in at moneylifeshow.com.

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