The Folly of Five Star Mutual Fund Investing

When I began my career in the financial planning and investment advisory industry I worked for one of the large brokerage firms in downtown Toledo.  As a trainee in the firm’s development program, I soon befriended another trainee.  I will call him Nelson.  Like me, Nelson was making a significant career change in joining the firm.  We got to know each other pretty well in the two years we spent together struggling through the training program and developing our respective businesses.  After two and a half years I left the brokerage firm to move to the Registered Investment Advisor side of the business, while Nelson remained with the brokerage firm.

A decade later, Nelson and I still see each other two or three times a year at professional education events or to catch up over lunch.  We share the latest news about our families, and discuss the comings and goings of old brokerage firm colleagues and the latest industry trends and developments.  Nelson and I have a lot in common, but over the years I’ve learned to avoid discussing one area where we have a significant difference in philosophy:  how to invest our clients’ money.

Nelson utilizes the brokerage firm’s fee-based mutual fund platform to invest the majority of his client’s assets.  This platform gives Nelson access to pre-screened mutual funds that are evaluated and ranked according to the brokerage firm’s criteria, which includes Morningstar’s ratings among other factors.  As you would assume, the brokerage firm’s recommendations are heavily populated with funds rated four and five stars by Morningstar.  Every quarter Nelson reviews the firm’s fund recommendation listing against the funds he has chosen to create a diversified portfolio for his clients.  While it does not happen every quarter, Nelson often switches one or two of the dozen or so funds in his clients’ portfolios based on the firm’s most recent quarterly evaluation.    Nelson genuinely believes that he is improving his clients’ investment portfolios with these changes.  Likewise, his clients have bought into Wall Street’s message that they have to own the highest rated mutual funds to reach their financial goals.  It does not cost the clients any extra money to make these changes because they are paying a flat advisory fee for the program.  So what is wrong with this approach?

Statistically speaking, there is plenty of evidence to suggest this approach is wrong.  Morningstar Inc., at the request of The Wall Street Journal, recently provided some data on the subsequent performance of five-star rated funds.  Of the 403 funds that had a five-star rating by Morningstar in July of 2004 only 58, or 14%, still maintained their five-star weighting ten years later in July of 2014.  Another recent study shows even more abysmal performance by top rated funds.  S&P Dow Jones Indices recently analyzed 715 funds they considered top performers in their categories.  In the four-year time span that ran through March of 2014, the study found that only two, yes two, of the 715 funds remained in the top 25% of funds.  For comparison purposes, that is an appalling 0.3%.

Dimensional Fund Advisors (DFA), the low-cost mutual fund solution we use for the vast majority of our clients’ assets, has known about this investing misconception for decades, and collected data associated with this phenomenon known as track-record investing, or investing in mutual funds based on their past performance.  DFA’s research confirms the findings of both Morningstar and S&P Dow Jones Indices:  a very small percentage of funds outperform their benchmark index, or even their competition.  In their most recent research compiled about the US mutual fund landscape, DFA found that only 19% of the 2,478 mutual funds around in existence for the ten-year period ending on December 31, 2013 outperformed their respective benchmark.  Perhaps more shockingly, only 52% of those 2,478 funds survived the entire ten-year time period.  The other 48% of the mutual funds were either liquidated or merged with other funds.

This data would seem to confirm the beliefs and philosophies of mutual fund firms like Dimensional Fund Advisors and Vanguard, and influential academic types like Nobel laureate Eugene Fama (University of Chicago) and Ken French (Dartmouth) that have concluded that nobody possesses the skills or knowledge necessary to consistently and correctly time securities markets or pick one security that will outperform others.  Instead, they would postulate that any time periods where mutual funds have outperformed their benchmarks were the result of random luck and not skill.  Moreover, they would also suggest that the best determinant of the future success of any mutual fund is low costs.

We may never definitively know whether funds receiving a five or four star rating from Morningstar do so as a result of investing skill and knowledge, or whether it is a result of dumb luck.  Statistical evidence would certainly seem to suggest the latter.  Hopefully the next time you consider investing a portion of your portfolio or retirement nest egg in a five-star rated mutual fund, however, you will do a little research to determine what are the likely reasons for the fund’s high rating, or you may find yourself owning the next one star rated fund.

Sources:  Wall Street Journal, Dimensional Fund Advisors “The Mutual Fund Landscape”, Morningstar, Inc. and S&P Dow Jones Indices