Look to the Stars

We are all guilty of it, me especially. When looking for a product online, a restaurant to try, or a movie to rent, we look at a crowdsourced ranking to determine if it is worthy of our time and/or money. Quick aside: I once caught myself reading reviews for a set of dinner forks on Amazon…not my finest hour. Not only does this behavior squash any sort of serendipity in our lives, but it completely magnifies herd or pack mentality. It also promotes a gamification of those ratings. I’m sure we’ve all gotten a request from a friend to leave a 5-star review on Google for their business that we may or may not have patronized. In the world of investing, this practice takes the form of looking at the ratings for mutual funds as a basis for investment decisions. My goal here is to explain the meaning behind these ratings and how you might incorporate them into evaluating your investments.

Morningstar is probably the most well-known company which provides fund ratings to investors. Their data and research are indispensable tools to investing professionals and retail investors alike. For mutual funds, they have two ways of grading: the star system and a medal system (gold, silver, bronze). An easy way of thinking about them is that the star system is backward-looking while the medal system is forward-looking. The star system is probably what most investors are familiar with so let’s start by breaking down what it is telling us. Without boring you with details, a star rating simply looks at a composite of trailing returns over different time frames, adjusts for risks, and then compares to similar funds. All funds of a similar style are then graded on a curve and a rating of 1-5 stars is assigned. Here’s where most investors get tripped up. They scan a list of funds, sort by star ratings, and invest accordingly.

This method of investing has two implications. First, little thought is given to portfolio composition or how each investment will potentially interact with one another within the account. For example, if an employee selects the only two 5-star funds available in her 401(k), she could be ending up with an undiversified, volatile strategy without realizing it. The second implication is from the fund’s perspective. Investors tend to allocate more money to funds with stellar track records leaving those funds flush with cash. Unable to let cash sit idly in the fund, the manager is forced to put that cash to work and investments that previously may not have made the cut suddenly become relatively attractive. What was once a streamlined, disciplined approach has now become a little more relaxed. Returns now suffer, star rating goes down, investors pull their money, and the cycle continues. This is a gross oversimplification of the process, but it should provide perspective of the challenges of just selecting 4- and 5-star funds. There’s also the chance that the fund’s prior returns were mainly a function of luck, but that discussion of active management is best reserved for another time.

The medal system is forward looking in that the analyst assigned to the fund scores it according to five pleasingly alliterative metrics: Process, People, Price, Performance, and Parent (as in, parent company). Those that excel in all five categories are assigned a gold rating. Four out of five is assigned silver and so on until the most undesirable negative rating. This ranking system is constructive because it provides a peek into the future based on factors that historically have been indicators of relatively good performance. Combining the two ranking systems together can put an investor on the right path, but it is only the first step. The caveats from the last paragraph still apply.

In The Lion King, Timon, Pumbaa, and Simba are lying on their back, looking at the stars, guessing what they are. Pumbaa, portrayed as somewhat of an idiot, correctly identifies them as balls of gas, burning billions of miles away. Our discussion of stars today hopefully provides some clarity on the matter as it relates to your investments. If you are intrigued as to what other elements go into portfolio construction, feel free to reach out to me for a discussion.