5 stars Voodoo Doll

The Curse of the Five-Star Rating

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5 stars Voodoo Doll

A recent Wall Street Journal article (“Mutual Funds’ Five-Star Curse”, 9/8/2014) should give pause to investors who only pick managers with the coveted five-star rating from Morningstar. As we have pointed out on many occasions, above average performance (which is the basis for the star ratings) has no persistency beyond what we would expect from chance alone. This is the consistent finding of the S&P Dow Jones Persistence Scorecard. Not surprisingly, the authors of the Wall Street Journal obtained a similar result when they tracked what happened with 403 funds that received a five-star rating ten years ago. The pie chart below depicts the results. Please note that we have adjusted the authors’ results for estimated survivorship because they did not account for the funds that had a five-star rating ten years ago but no longer exist today.

As you can see, if you started with a five-star fund ten years ago, you had about a one-in-nine chance of still having a five-star fund today—not very good odds. One of the noteworthy fallen angels from the five-star list is the Fairholme Fund (FAIRX), whose manager Bruce Berkowitz was awarded Morningstar’s Fund Manager of the Decade at the beginning of 2010. Although 2010 was a good year for FAIRX (it beat the S&P 500 Index by 10.4%), it stank up the room in 2011, lagging the S&P 500 by 34.5%. It seems that FAIRX had a significant amount of concentration risk that went against it. Some of its investors may not have realized that they were taking on a lot more risk than the S&P 500. FAIRX now has two stars.

Another former five-star fund singled out by the authors is the Columbia Marsico International Opportunities Fund (MAIOX). It now has one star, and over the ten years ending 6/30/2014, it has had an annualized return of 5.93%, but its investors (as a whole) have had an annualized loss of 4.83%. It appears that they dumped in a lot of cash just before the fund suffered a 50.8% drop in 2008. All we can say is that we have seen this flick before, and it does not have a happy ending.

So what should investors look at when choosing a fund, Morningstar’s Russel Kinnel said it best in Morningstar’s own study that found expense ratios to have greater predictive power than star ratings:

“If there's anything in the whole world of mutual funds that you can take to the bank, it's that expense ratios help you make a better decision. In every single time period and data point tested, low-cost funds beat high-cost funds.”