Is This All We Really Need To Know?

TCI

Sep 29, 2010


This sketch by Carl Richards originally appeared in The New York Times. More of his sketches can be found at Behaviorgap.com.

Earlier this month two clients asked me to address the fact that few DFA funds had a Morningstar rating of greater than 3.
That got me wondering if there were any recent studies that looked at Morningstar ratings. I knew there were studies that showed little predictive value of “Stars” but the rating process was changed in 2002.
What I found was a recent study by Morningstar itself. The results are summarized below:
Morningstar examined five broad categories of equity and fixed-income funds over multiple periods beginning in 2005, 2006, 2007 and 2008 and ending in March 2010. Funds were sorted into quintiles based on expenses and the performance of the cheapest funds was compared to that of the most expensive. They computed total return for funds surviving through March 2010 as well as a “success ratio” measuring the percentage of the initial cohort that went on to survive and outperform their peers.
Unsurprisingly, cheap funds outperformed their expensive cousins. Commenting on the results, Morningstar Director of Mutual Fund Research Russel Kinnel observed: “In every single time period and data point tested, low-cost funds beat high-cost funds”
A similar exercise evaluated the same funds using the Morningstar Ratings assigned at the beginning of each time period. The ratings showed predictive power as well, although not as pronounced as the expense ratios. “In general,” Kinnel states, “5-star mutual funds beat 1-star funds on our three measures, although there were exceptions. All told, the stars guided investors to better results in 59 out of 70 (84%) observations.”
So which measure is more useful for investors – funds expenses or ratings? Morningstar declines to crown a champion, finding merit in both. Expenses were a more reliable predictor (“they worked every time”), while stars could be helpful “In identifying funds that might be merged out of existence.”

Click here to see the report.

Russel Kinnel. “Fund Spy – How Fund Expense Ratios and Star Ratings Predict Success” Morningstar, August 9, 2010

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