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How important is picking mutual funds with 4 or 5 stars from Morningstar versus funds with extremely low fees?

Jan 04, 2012 by Dan from Ventura, CA in  |  Flag
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21 votes

Not important at all. The star system at Morningstar is predicated on how the fund has done historically. You’re probably not interested in betting on a horse that ran the Kentucky Derby in 2011, right? Morningstar is working on improving its ratings system and has begun incorporating more forward-looking criteria, but it’s a work in progress. As for fees, they are one of the investor’s natural predators along with taxes. There are very few funds in this world, 5 star or otherwise, that are worth paying up for.

1 Comment   |  Flag   |  Mar 13, 2012 from Manhattan, NY
Tony Krance, MBA, CFP®, AIF®

I agree. There is no correlation between past performance and future results. Even Morningstar admits its rating system has no predictive value. The academics teach us that the is unpredictable and random. We also know that asset allocation accounts for over 90% of performance. There are three simple rules of investing own equities and high quality short term fixed income, globally diversify and rebalance. Work with a fiduciary adviser to build a prudent portfolio designed for you and help you remain disciplined.

Flag |  May 02, 2015 near Green Bay, WI

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10 votes

I frankly don't pay any attention to the Morningstar stars, though as Julian mentioned they have changed their fund ranking system so it will be interesting to see how this system works as a predictor of future perfomance.

Low fees are a great starting point. As one who starts with an asset allocation plan (as do many of my advisor peers) I look for opportunities to implement that allocation with low cost index funds/ETFs where it makes sense. With an index fund cost and adherence to the underlying index are all that counts.

Beyond that when and where I use actively managed funds, expenses are still important. Not so much that the fund needs to be the cheapest in its peer group, but I find that most of the active funds that I use have competitive expenses. I've not found a fund manager who is good enough to consistently justify costs that are well above average.

Comment   |  Flag   |  Feb 23, 2012 from Arlington Heights, IL

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7 votes

Star ratings offer a good view of what has already happened. It is useful to evaluate a fund's past performance and understand why it did or did not do well, but it may not be as useful in trying to determine how a fund will perform going forward. Low fee funds, like index funds, may be appropriate for investors who don't want to do a lot of analysis, and a number of these will have a higher star ranking. But buying an index fund or two is not much different than buying a 5-star fund because the purchase decision misses the point of all the questions you should ask BEFORE you consider what funds to buy. You should develop an investment plan based on your specific goals and time frame, and only then evaluate which asset classes and combinations of asset classes will best serve you. The choice of funds is subservient to these decisions. Don't put the cart before the horse; do your planning first. PS - low fees are good, but they are not the only consideration.

1 Comment   |  Flag   |  Jan 12, 2012 from Arvada, CO
Evan M. Levine, ChFC

Good point Victor. Some data shows an inverse relationship between Star Ratings from one block of time to the next... further supporting that there is no serial correlation in the capital markets.

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Flag |  Jan 13, 2012 near Port Washington, NY

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4 votes

Star rating change...Morningstar even just changed their rating system to reflect the underlying process of funds rather than just rank on a star system. I feel underlying fees are more important when comparing index funds...they essentially are holding the same investments, i.e. the S&P 500, so in that example you would be best served by choosing the fund or ETF (if you have access to ETF's) with the lowest fee as you are paying for passive management, not active management.

Comment   |  Flag   |  Jan 05, 2012 from Boston, MA

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3 votes

Low fees, historical performance, star ratings, etc. are important to analyze, but it is imperative to consider (among other things) where we are now in the economic environment. I believe many investors make the mistake of seeing a five-star rated security with solid historical performance, and immediately buy without thinking of any other relevant factors. Make sure you incorporate leading economic indicators when making your decision.

Comment   |  Flag   |  Apr 28, 2015

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1 vote

If your interest in academic research on the effectiveness of the Morningstar rating system, you may be interested in these papers:

Antypas, Antonios and Caporale, Guglielmo Maria and Kourogenis, Nikolaos and Pittis, Nikitas, Selectivity, Market Timing and the Morningstar Star-Rating System (April 1, 2009). CESifo Working Paper Series No. 2580. Available at SSRN: http://ssrn.com/abstract=1360637 or http://dx.doi.org/10.2139/ssrn.1360637 (Higher ranked funds had higher future returns, especially based on stock selection ability)

Morey, Matthew R. and Gottesman, Aron A., Morningstar Mutual Fund Ratings Redux (January 2006). Available at SSRN: http://ssrn.com/abstract=890128 or http://dx.doi.org/10.2139/ssrn.890128 (For domestic equity funds, Morningstar ratings, predict returns in a monotonic fashion - 5 star better than 4 star, 4 star better then 3 star, etc.)

On the role of risk in the Morningstar rating for mutual funds, Francesco Lisi , Massimiliano Caporin, Quantitative Finance, Vol. 12, Iss. 10, 2012, http://paduaresearch.cab.unipd.it/7161/1/2009_20_20091204171051.pdf ( Results show that the current Morningstar classification, based on a risk-adjusted measure, only marginally accounts for risk)

Comment   |  Flag   |  Mar 11, 2015 from Appleton, WI

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1 vote

Paying reasonable fees is a great place to start. Just don't forget the difference between price and value. Price is what you pay and the value is what's received. So if adding a more expensive fund will add value going forward then despite it's current star rating it just very well may be worth it. Paying attention to the upside and downside of a fund makes more sense to me personally. If a fund has a 7% average rate of return but lost 40% in a year like 2008 then maybe that fund offers more risk and volatility than i would personally care to take regardless of fees or star ratings. Know this, asset classes are cyclical and yesterdays winners are often tomorrows losers.

Comment   |  Flag   |  Apr 01, 2015

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1 vote

The Morningstar Rankings are helpful measurements for risk and return of a particular mutual fund. Low fees are also a very important consideration although should not be the only consideration. A fund's (or fund manager) ability to navigate through periods of poor market performance should also be considered. Extreme volatility and large draw-downs can be just as damaging to a long-term portfolio as high fees. In other words, try to avoid funds that can only do well in a bull market.

Comment   |  Flag   |  Apr 07, 2015

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1 vote

I think Morningstar does a good job overall of assigning ratings. From my experience, most 5 stars funds are ones that are actively managed and have done a good job beating their peers over time. Of course, that doesn't mean they will continue to beat them.

I am personally an advocate of a hybrid approach, using some index funds and some active funds. Index funds work well in some areas, like domestic large cap, but may not be as good in other areas, like foreign equity. There are more variables in international investment that make it advantageous to have the flexibility to deviate from a benchmark. This can include different GDP growth rates from country to country, political strengths and weaknesses, movements in the foreign currencies, and geographic strengths and weaknesses.

A good active fund manager in areas like foreign equity and emerging markets should be able to beat their respective indexes net of fees and taxes over time.

Comment   |  Flag   |  Jun 25, 2015 from Austin, TX

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0 votes
Steve Casull Level 13

Read the small print at the bottom of every Mutual Fund advertisement, "Past performance is not indicative of future performance". Also, Is the fund being managed by the same manager that happened to garner the higher star tally? Rarely will you be able to pick the best performing fund. So don't pop any blood vessels trying to. Find an ULTRA LOW fee Financial Advisor that doesn't call you "Bud", and keep your debts under control.

Comment   |  Flag   |  Mar 13, 2015 from South Jordan, UT

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