Sign up today and take advantage of member-only content — the kind of timely, cutting edge industry insight that only Money Management Executive can deliver.
  • Exclusive Online Only Content
  • Free Daily Email News Alerts
  • Asset Management Blogs

Most Top-Rated Mutual Funds Are in the Red

Of the 510 mutual funds that received five-star ratings from Chicago fund tracker Morningstar at the end of July, 83% of them were posting negative returns, with an average negative return of 9.23% year to date.

Morningstar isn't alone in this misery. New York-based fund analyst Lipper has seen its top-rated Lipper Leaders funds decline, as well. Sixty-one percent of the funds that Lipper rates for "consistent return" have posted negative returns so far this year, with the average loss at 5.48%.

So, if rating systems are supposed to help investors choose funds, what good are these ratings during a protracted bear market, anyway? Not much, financial planners and investors say.

"Ratings are useless in a bear market," said an investor in Los Angeles, who asked not to be identified. His only mutual fund holding is the Rydex Ursa fund, which shorts the market. "How can they rate a fund's performance when we are just getting rallies within a bear market? Ratings are only good when they are based on steady, bull-market years."

But fund companies still hawk their high ratings. Morningstar's ubiquitous star rating system, which rates more than 6,500 funds with one to five stars, is widely used by advertisers to promote their funds, even in this bear market.

No Guarantees'

"The five-star rating is of absolutely no value," said Ric Edelman, a financial planner and author in Fairfax, Va. "Investors who buy funds based on the star rating are highly likely to be disappointed, or worse."

The reason, Edelman said, is that the ratings rely on past performance data, which, as the fine print reads, is "no guarantee of future results." So, in this volatile market, it's no surprise that an astounding number of funds with five star ratings are now yielding negative returns, he said.

For example, Morningstar data shows that the five-star Smith Barney Aggressive Growth fund has posted year-to-date returns of negative 34.91%. Likewise, the North Track PSE Tech 100 Index fund, also five-star, is down 34.69%. And the five-star Star Goldman Sachs Growth and Opportunities fund has erased 29.53% from investor's assets.

Critics say the star rating system promotes the idea that a top-rated fund will yield stellar returns.

In fact, a study that was released late last year by the University of Oregon and the Federal Reserve Bank of Atlanta said that a five-star rating can bring a previously un-rated fund as much as $26 million in additional assets, 53% more than the expected normal flow [see MFMN 9/10/01]. In addition, funds that Morningstar upgrades from four to five stars attract an additional $44 million, 35% more than the normal flow, the study found.

"The media and the industry do this to perpetuate this myth," Edelman said. "One camp [promotes five-stars] because they're crooks. The other camp because they're idiots. You decide which is which."

"I don't think year-to-date performance tells you anything about anything," said Mercer Bullard, a former assistant chief counsel in the SEC's division of investment management and now a shareholder advocate.

To be sure, this bear market has pounded Morningstar's top-rated portfolios. An analyst at the firm said comparison data is skewed because of recent changes to the way Morningstar rates funds [see MFMN 4/29/02], but the data shows that, as of July 31, 2001, 53% of five-star portfolios were in the negative. But an astounding small, .02%, of them were posting negative returns as of July 31, 1999. Comparison data was not available for Lipper's rating system because it was launched only last year.

Russ Kinnel, a Morningstar senior analyst, said that only 3% of domestic equity funds currently show positive returns. "It's a bear market," he said. "It's kind of obvious a fund's going to be in the red."

Morningstar says the star-rating system is simply a guide and that investors should conduct their own additional research before they invest. For example, Kinnel said, investors should consider whether a portfolio manager has managed a fund for a long period, whether the fund allows for proper asset allocation and whether a fund complex is skilled at managing certain portfolios. If a complex opens an international fund, for example, investors should be sure the firm has experience picking international stocks.

"The star-rating is a good first screen," Kinnel said.

In addition, Kinnel pointed out that recent changes to the star-rating system last spring have improved the ratings' applicability. Previously, the firm compared funds across four broad categories. Recently, Morningstar started comparing funds only to their peers in 50 specific asset classes, such as "specialty technology" and "diversified world' [see MFMN 7/1/02].

Yet some find the ratings systems helpful.

"I pay attention to the stars, of course I do," said Linda Barlow, a financial planner who runs a practice of about 125 regular clients in Santa Ana, Calif. "It's really hard to ignore in dealing with the public. They look at that a lot."

Avi Nachmany, an analyst at the New York research firm Strategic Insight, said that the star rating "just identifies some funds with a better probability of success."

"It does not ensure that you will not lose money," he said.