Many investors turn to Morningstar when evaluating funds. The company has built an entire business on ratings, using the famous five-star system that many of us are familiar with. But while funds like to tout their ratings and investors rely on them to determine what constitutes a “good” fund, ratings may not be terribly significant.
Funds with a three-year history all have ratings ranging from one star (lowest) to five stars (highest). To determine its star ratings, Morningstar looks at risk-adjusted trailing performance. As part of the formula, Morningstar does include costs, considering returns that come after fees are deducted.
However, the fact that past performance is a huge part of Morningstar’s rating system means that there is a big problem with how meaningful the ratings actually are.
Past Performance and Future Results
Investors are familiar with this refrain: “Past performance does not guarantee future results.” This means it’s necessary to question the weight of a star rating system that’s based on what has happened in the past. If past performance can’t be taken as an indicator of future results, Morningstar’s ratings might not be as consequential as expected.
However, past performance can provide clues about a company and its likely health. From that standpoint, looking into the past isn’t a bad idea. But relying heavily on Morningstar ratings to help you choose a fund that will perform in the future might not be in the best interest of your investment portfolio.
Could Expense Ratios Be More Meaningful?
Instead of relying on Morningstar ratings, you might actually be better off checking expense ratios. Russel Kinnel, Morningstar Director of Research, has addressed the issue of star ratings vs. expense ratios. He basically hedged on the usefulness of the ratings from Morningstar and pointed out that expense ratios offer a better gauge of how a fund is likely to perform in the future.
The problem is that many funds, especially index funds, are going to deliver average returns when compared to the market. A lower-cost fund, therefore, provides you with the best chance of doing well. When shopping around for a fund, therefore, you might be better off taking a look at the expense ratios, and not paying as much attention to what star rating Morningstar provided.