Swedroe: Investor Biases & Mutual Funds

March 08, 2019

The 2010 study covered the period June 30, 1992 through August 31, 2009. The 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.

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.”

Other studies have come to similar conclusions. For example, Morningstar’s own 2010 study found that expense ratios were a better predictor than its star ratings.

Investors reveal their preferences and dislikes by how they allocate capital across active mutual funds. The evidence presented shows that investor allocations are influenced by Morningstar’s ratings (which overweight recent performance, weighting 10-year performance more than five-year performance, and five-year performance more than three-year performance) and their own recency bias, increasing cash flows to funds that have performed the best in the most recent period.

Sadly, it appears that investors are generally naive as to adjusting performance for risk, are subject to recency bias, and ignore the evidence that star ratings have little value. Education doesn’t have to be expensive, but ignorance can cost you dearly.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.

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