Be Cautious When Studying Mutual Fund Ratings

Wherever you look, you will find various rating systems on mutual funds, each of which uses a different approach. All of them are designed to weed through the thousands of funds to get to the best ones. But is there really such a thing? Does a high rating really mean a fund will do better in the future? Many people seem to think so. A recent study showed that Morningstar, North America's most recognized rating system for funds, has a tremendous influence on fund sales. If Morningstar gives a five-star rating, those funds typically enjoy increased sales as a result.

While ranking providers are careful to warn investors that their ratings don't foretell the future, the star system is, unfortunately, used by some investors as if they were reading Consumer Reports to purchase a new drill. Supporters of the ranking approach argue that there's no subjective component to the star rating. It isn't determined by an analyst's review, and can't change simply because the service dislikes the fund's manager or its investment strategy. And that's good.

Performance will vary. Fund performance often falls off and risk levels rise during the subsequent three years after a fund is given an initial five-star Morningstar rating, suggests another recent study by Matthew Morey, a professor at Pace University. One reason for this is that after receiving a five-star rating the size of the fund grows dramatically, which then makes the fund unwieldy to manage, he suggests. Since Morey's study was completed, Morningstar also has changed the way it doles out top rankings to make them more precise. One of the biggest problems with all rating systems is that they are not necessarily predictive in nature. This means they're not really set up to tell you whether certain funds will necessarily do better in the future. For the most part, the ratings indicate how much you might have made and how much aggravation you faced in the process.

Combining risk and return. For example, one five-star fund might post moderate return scores, but incredibly low risk scores. Another five-star fund might have much higher-risk scores, but its return score could be strong enough to help it still rank in the top 10% of the pack.

In some cases, in fact, it's not even the same fund to begin with. Remember, after a management change, the rating stays with the fund, not the portfolio manager. Therefore, a fund's rating might be based almost entirely on the track record of a manager who is no longer with the fund.

Understand how the ratings were developed. Too many people put emphasis on the results without knowing how the results were achieved. If you are going to use ratings, take the time to understand how they were developed and what they really mean. It is not the destination but the journey that counts.

Past performance is no guarantee of the future. You have probably heard this disclaimer a thousand times before, but it is really important to understand. Most rating systems have little to no predictive element in them. It's natural to think that the best performer of the past will be the best performer in the future. Unfortunately, it's not that simple. Just think about it; if it were that easy, investors would just continue to buy last year's winners knowing that they will be this year's winners. And that seldom works.

Ratings are a very important element in trying to distinguish between good and bad funds. Good research, however, goes far beyond just looking for five stars or an A+. When evaluating funds, look at the quantitative, measurable characteristics of a fund: returns up against the benchmark, costs, risks, taxes and manager tenure. Use rating systems as part of your research, but remember: just because the analysts give them top marks, it does not mean they will be the best investment in the future, and doesn’t it mean that they'll be the best investment for you in particular. Take the time to understand how the ratings were achieved. This will be the first step to educating yourself about funds.

Types of Mutual Fund

Stock Funds

1. Stock funds are the most common type of mutual fund, and they invest exclusively in common and preferred stocks. They are the most volatile type of mutual fund. This category includes many different types of funds, which are designed for investors with various objectives. Typical stock funds include growth funds that seek capital appreciation through companies that are likely to experience significant growth, value funds that look for companies whose stock may be undervalued, and balanced funds that seek a combination of the two. Other popular types include sector funds that invest in particular industries, and index funds that seek to mimic the performance of a particular stock index like the Dow Jones Industrial Average or the Standard & Poor's 500, by investing in all the stocks in one of those indexes.

Bond Funds

2. Bond funds are suitable for investors who are looking for long-term income. Bond funds tend to be significantly less volatile than stock funds, but their price still fluctuates depending on the movement of interest rates. Bond funds may invest in short-, medium- or long-term bonds and in bonds of varying degrees of safety. In general, funds that invest in low-rated bonds (such as "junk bonds") pay the highest returns in the short term, but in the longer term they carry the highest risk, as these bonds carry a higher probability of default. Bond funds may experience capital appreciation when interest rates are falling, but typically they are not held for this purpose.

Money Market Funds

3. Money market funds are funds that invest exclusively in short-term money market securities like treasury bills, certificates of deposit and commercial paper. Their goal is to provide interest income to the shareholder, not capital appreciation. Money market funds attempt to keep their net asset value fixed at $1.00 per share and are required by law to invest in low-risk securities. Many money market funds have check writing privileges, allowing the shareholder to use them essentially as interest-bearing checking accounts. Money market funds are a good place to park excess short-term cash but are not suitable for those seeking significant growth in the value of their investment.

Load vs. No-Load

4. Some stock and bond funds have a sales charge (or load) that the investor must pay to buy shares in the fund. This charge is deducted from both the initial and any subsequent purchases that the investor makes in the fund and reduces the value of her investment. Typical load charges range from 1 percent to 3 percent of the amount invested. Load funds tend to be specialized, such as sector funds, but also may be funds run by a successful or popular fund manager. By contrast, no-load funds have no sales charge and the full amount invested is used to purchase shares.

Mutual Fund "Families"

5. Many mutual funds are managed by so-called families, which market several different funds under one corporate umbrella. Examples of fund families include Fidelity, Vanguard, Oppenheimer, and T. Rowe Price. Investing in a fund that is part of a family has several advantages. Fund families will supply the investor with information about all of their funds, and typically only one application is required to invest in the entire family. Also, most fund families allow the investor to easily switch his investment between any of the funds in the family. Most fund families also offer money market funds as a convenient place to park cash between investments in their various funds.