Steve's answer is spot on. I would add that you might want to skip mutual funds and look into exchange traded funds.
When looking at an investment, its very important to consider the expenses and Morningstar will be the first to tell you.
Morningstar actually did a study on your exact questions of stars vs expenses here: http://news.morningstar.com/articlenet/article.aspx?id=347327&part=1
The chart they link to in the study is here which I find interesting: http://news.morningstar.com/PDFs/spychart0810.pdf
The summary is that Morningstar found expenses had a greater future perfomance predicting ability than the star system. Although the star system did have positive results as well.
One of the strengths of the star system is that it does a good job punishing the high expense funds.
When doing your evaluation, you will want to make sure you are comparing apples to apples.
1) Index funds should be compared to other index funds and passive (index) ETFs. There is no reason to own a higher expense ratio index fund and there is a surprisingly high number of them still in existence. In particular, I have seen in some 401ks and 403b's where the expense ratio of the index is not competitive.
2) Compare active managers with active managers for their expense ratio. 0.50% might be high for an index fund but for an active manager in the microcap space, it might be a bargain.
3) For a "do it yourself" investor, you should compare the extra cost your are paying for the active manager vs the cost of the index fund. The extra cost of the manager is what you are paying for the chance to do better than the index. Simply, you are making a bet if the manager can beat the index. Often times, its much easier for a "do it yourself" investor to use the index fund. Even as a professional that evaluates managers, I often find myself using an ETF or index fund in areas where I do not feel confident in a managers ability to beat the index.
Thanks and good luck, Steve
Past performance, risk and volatility analysis are important parts of the process during fund selection, but those pieces alone don’t tell the whole story. The star rating tells me how the fund has done in the past; but methodology, management, volatility levels during both good and bad markets, portfolio construction philosophy, and several other factors are more indicative of the potential a fund has to perform going forward.
I’ve always believed that in the absence of value, fees are an issue. Passive investments are easier to cost compare and due to their operating structure, appropriately should have lower fee levels. Actively managed funds usually command higher fee levels than index funds, but should still remain competitive within that investment sector.
Bottom line, it comes down to balance for investors. Chasing performance and/or hunting down funds only based on their fee structure is not a winning long term strategy. Proper fund analysis, including performance, volatility and fee structure should be done, but only as part of an overall portfolio that is rooted in proper asset allocation. The vast majority of total return over a long period of time is generated through proper diversification and asset allocation. That is where experience, constant monitoring and vigilance, and portfolio rebalancing is done in conjunction with an investor’s tolerance for risk and financial goals.
It is easy to find low-fee funds with 3 or more stars-- you want both. Check that the number of stars has been there for 5 or more years or is going up. Don't use just one fund, spread your investment around with other funds that invest in different stocks.
The star system is basically irrelevant. They even admit that it's a flawed system and doesn't give the investor any valuable information. But, they have to sell subscriptions......All of the above is great advice. Consider ETF's or low cost funds.