By Jamie Dlugosch of Investor Place
The mutual fund industry is crowded and complex. With literally thousands of funds to choose from, no wonder investors can become confused.
The rating agency dominates the landscape of those monitoring the mutual fund market, and its simple five-star ratings system has become the gold standard with respect to evaluating mutual funds.Morningstar uses a formula of long-term and short-term performance adjusted for risk and expenses to determine its rankings. Five stars is the highest rating and one star is the lowest. Going further, Morningstar has cleverly placed funds into what it calls style boxes that slice and dice funds based on size and investment approach. Investors can take the combination of the ratings and style boxes to help make investment decisions. THE FLIP SIDE It sounds rather simple, and we should all be thankful Morningstar has gone through such efforts to sort through such a complex maze for investors. But ... hold on one second. While there is much good to be said about Morningstar and its rating system, there is danger lurking in any attempt to make the complex so simple. As everyone should know by now, past performance does not guarantee future success. In fact, one could argue that the very use of past performance as a way to rank funds looking forward is a mistake. If anything, a highly rated fund may not be able to sustain the types of returns that made it highly rated in the first place. Prudent investors may want to lock in gains by selling highly rated funds instead of buying more shares as the high rating would suggest you do. The flip side of that equation is true as well. Investors looking for an edge may wish to consider owning a fund that is poorly rated with the idea being that, in the future, superior performance is just around the corner. Think of it as a contrarian approach. Mutual funds can perform poorly for any number of reasons, and Morningstar's ranking system does not take out such noise. For example, a mutual fund's style can be out of favor for such a period that the Morningstar rating will drop significantly as a result. By the time the style becomes vogue, Morningstar would have you believe the fund is a dog. That is simply not true.