Faculty Research: Improving on Morningstar's Ratings
Past returns on mutual funds provide little or no help in choosing the best mutual
funds going forward, says Dr. Thomas Howard of the Reiman School of Finance. Yet,
despite this, many investors and advisors continue to rely on past performance when
making investment decisions.
In his article, "Improving on Morningstar's Ratings" in Advisor Perspectives newsletter, Dr. Howard cites research conducted through his firm, AthenaInvest, whereby he analyzed the strategy consistency and focus of the 3,000 U.S.-based mutual funds between 1997 and 2009. Consistency measured how stocks' stated strategies compares with their actual strategy, while focus measured the extent to which the funds held high-conviction positions in the portfolio.
"These two measures provide an up-to-date snapshot of how the manager is executing his or her stated strategy," Dr. Howard wrote. "It is important to note that no past performance is included in either of these measures."
Dr. Howard gave funds with the highest level of consistency and focus a DR5 (diamond rating five) rating and those with the lowest levels a DR1 rating. Between March 1997 and June 2009, DR5 level funds outperformed DR1 level funds 82 percent of the time.
"That result is of particular interest," wrote Dr. Howard, "since over this time period, average DR1 fund performance was roughly in line with S&P 500 performance. DR5 funds during this time generated an average annual excess return of greater than four percent and had an 82 percent chance of beating the market."
Only in 1997 and 1998 did Dr. Howard's designated DR5 funds not outperform the market. From 2000 to 2009, DR5 funds dominated. "Most recently, DR5 funds have outperformed all other ratings in each year from 2007 to 2009. This is particularly impressive since 2008 was a terrible bear market, while 2009 was a strong bull market, which indicates that highly consistent, focused managers successfully navigated these exceedingly difficult markets."
It was also in this full market cycle that Morningstar's methodology had the least predictive power. The popular fund monitor uses a weighted average of three-, five- and 10-year historical fund performance to assign its ratings. Dr. Howard examined more than 500,000 fund-month observations between January 1980 and June 2008 and concluded that weighted historical returns can't predict future fund performance.
Read the full article at advisorperspectives.com, Vol. 4 No. 25 (June 2010).
