Investing tip: mutual fund ratings can be useless
Many people think they can find the best mutual funds, just as they believe they can pick winning stocks. The tool most people rely on to do this are the ratings provided by agencies like Morningstar and Lipper.
These ratings have a tremendous impact on individuals’ decisions about where to invest their money. According to Financial Research Corp, for example, funds with four or five star ratings took in nearly $80 billion of new investor money in 2002, whereas lower-rated funds suffered withdrawals of over $108 billion.
But here’s the problem.
Recent research by Professor Matthew Morey of New York’s Pace
University shows that funds with high Morningstar and ValueLine ratings
don’t necessarily perform better than those with lower ratings. Here’s
one particularly poignant example: according to the Wall Street
Journal, at the end of 1999, 90% of Morningstar-rated tech funds had 5
stars. Oh dear.
Despite their predictive failure, the mutual fund companies themselves
exploit the Morningstar and Lipper ratings in their advertising. In a
paper called Fund Families and the Star Phenomenon, three academics at
the University of Michigan in Ann Arbor showed that by touting good
ratings for their “leading�? funds, the fund companies succeed in
attracting money to their other funds too. And of course, the aggregate
performance of the most heavily advertised fund families is no better
than average.
Here's more evidence that investors pick mutual funds using criteria
with no predictive validity: recent research has shown that if mutual
funds change their name, for example by adding the word "growth" to
their title, and raise their upfront fees (loads) or 12(b)1 fees
(additional fees largely used for marketing and compensating brokers
who push the funds), they actually attract more money.
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