Can We Gauge Future Fund Performance?

Those most elusive of magic bullets -- indicators that would predict the future performance of mutual funds -- may now be in reach for investors.

It's been a long time in coming. Hundreds of studies showed that past performance could be deceiving, though many investors had a tendency to look at that as a major driver of their fund choices. Factors such as fund size provided only limited guidance.

But recent research now suggests that there are reliable ways to pick funds.

The most notable advance has occurred with the ubiquitous Morningstar star system. Throughout the 1990s, academics complained about the stars. Studies showed that the system was almost useless for predicting future performance. Top-rated five-star funds didn't necessarily outdo funds carrying the lowest ranking of one star.

Hearing the complaints, Morningstar revised its stars in 2002. Now the new system has been operating for more than five years, and the results are noteworthy. On average, funds that received five stars in 2002 went on to outdo four-star choices over the next five years. Four-star funds surpassed those with three stars, and so on. The results proved consistent in nearly every category.

The average five-star international equity fund returned 20.05% annually during the five years. International funds with four stars returned 19.73%, and three-star winners returned 18.85%.

The system had particularly strong predictive value for balanced funds, which hold mixes of stocks and bonds. During the five years, the average five-star balanced fund returned 11.08%, while one-star funds returned 8.14%.

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