Swedroe: Chasing Active Outperformance Ratings

October 25, 2017

The paper “Mutual Fund Ratings and Future Performance” from Vanguard provides further evidence on the ability of star ratings to predict the future.

Authors Christopher Philips and Francis Kinniry Jr. examined excess returns over the three-year period following a given rating.

They chose the three-year period because Morningstar requires at least three years of performance data to generate a rating, and investment committees typically use a three-year window to evaluate the performance of their portfolio managers.

The 2010 study covered the period June 30, 1992 through August 31, 2009. Following is a brief summary of the authors’ findings:

  • 39% of funds with five-star ratings outperformed their style benchmarks for the 36 months following the rating, while 46% of one-star funds did so.
  • All the star-rating groups produced negative excess returns in the succeeding three years. Even worse, the four- and five-star figures were more negative than those of lower-rated groups.

No Signal Of Success

Philips and Kinniry concluded: “Higher ratings in no way ensured that an investor would increase his or her odds of outperforming a style benchmark in subsequent years.”

In fact, they found that “5-star funds showed the lowest probability of maintaining their rating, confirming that sustainable outperformance is difficult. This means that investors who focus on investing only in highly rated funds may find themselves continuously buying and selling funds as ratings change. Such turnover could lead to higher costs and lower returns as investors are continuously chasing yesterday’s winner.”

The bottom line is that using Morningstar ratings to identify future outperformers is like driving forward while looking through the rearview mirror; their ratings system does a great job of “predicting” the past. That applies to not just all rated funds, but even to FMOY winners.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

 

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