Morningstar Stars

“Fidelity Contrafund lost 37% last year. Why does Morningstar rate it so high?”
-Dan | San Diego, CA

Great question, Dan.  The Morningstar Rating is a very widely published measure, even used within the financial advisory industry quite frequently as a research data point, but the truth is many people don’t even know what it means.  Obviously, a 5-star fund should be a brilliant performer, right?

The Morningstar stars are actually based on their proprietary method of comparing risk and return.  This means it is an objective measure, rather than a subjective opinion.  Return is an easy and straightforward concept.  Risk is a little more difficult.  The idea of risk as applied to investments is often measured by volatility, in this case the variation of returns from month to month.  Morningstar then applies a “penalty” on a fund’s returns in relation to that risk. Funds are then awarded stars based on their “risk-adjusted” peer returns over a number of standard time-periods.  A 5-star fund would exhibit a better “risk-adjusted” return than 90% of funds in it’s same Morningstar category.

While the concept of volatility does not paint a complete picture of the risks involved in investing, it is the most easily quantifiable measure of risk and covers the basic idea that a fund should be ranked higher for delivering a great return with low risk.  William Danoff is one of a few great mutual fund managers and his ability to navigate the enormous Fidelity Contrafund to a risk-adjusted return bettering 90% of other Large Cap Growth mutual funds is a testament to his skill.

However, one of the many problems with actively managed mutual funds is that investment management in itself is a business.  Danoff was awarded the 2007 Morningstar Domestic Equity Fund Manager of The Year.   A large part of earning this award is marketing, and in this case keeping your fund in front of Morningstar, which in itself is in the business of investment marketing.  The truth is that more than 3/4 of actively managed mutual funds underperform their benchmarks, and chances are your 401(k) choices are limited to many of these mutual funds.  They lose your money, and you are “forced” to pay them anyway.  This means that while Danoff might be a great fund manager, in the eyes of the Morningstar Rating it also might be like comparing my 100m butterfly times to that of Michael Phelps.

I have worked for an investment advisor that solely used actively managed mutual funds for their portfolios, and also for an investment management firm that runs some brilliant 5-star rated mutual funds.  Let me tell you that consistently beating the market as a fund manager is an arduous task, and picking a basket of mutual funds that can do that may be even harder. If you have the choice in your 401(k) of a more broadly investable index mutual fund, say a Total Stock Market type index fund, this might be a stronger choice if you find yourself stuck with a bunch of 3-star rated funds. If you’re managing an account with more investment options, say your own IRA or taxable account, index mutual funds or index ETFs might be a significantly wiser choice.  Morningstar also has ETF ratings, the usefulness of which is highly questionable.

Monday, February 16, 2009, 14:58 | posted in explained | 1 comment »