This Day On The Street
Continue to site
This account is pending registration confirmation. Please click on the link within the confirmation email previously sent you to complete registration.
Need a new registration confirmation email? Click here

Morningstar: Getting the Most Out of Its Ratings

NEW YORK ( TheStreet) - Can the past performance of mutual funds predict future results? Probably not, say many academic researchers. To avoid disappointments, investors should steer away from actively managed funds and stick with passive portfolios, they contend.

But fund tracker Morningstar (MORN - Get Report) takes a different view. Morningstar analysts screen reams of data, searching for reliable indicators of future fund performance. The researchers claim to have found useful measures. No single indicator is foolproof. But Morningstar says that by using the right data points, investors can stack the odds in their favor.

Among the best known fund indicators is Morningstar's rating system, which awards each fund from one to five stars. Funds with the best risk-adjusted past performance receive five stars. Morningstar vice president John Rekenthaler says that the stars are "mildly predictive."

In a recent study, Rekenthaler looked at how stock and bond funds performed over five-year periods. On average, funds that received five-star ratings went on to return 7.3% annually during the next five years. One-star funds returned 6.5%.

While the low-rated funds only trailed by a small margin, they were clearly inferior in one respect: many went out of business. Of the 1-star domestic stock funds that existed in January 2006, 55% closed or merged out of existence during the next five years. Only 9% of 5-star funds disappeared, and 18% of four-star performers closed. The data on fund closures is worth considering. When funds shut down, shareholders must go through the inconvenience of finding new investments. So the best course is to avoid 1-star funds.

Along with the stars, Morningstar also gives grades to fund companies according to how well they serve as stewards of shareholder assets. Grades range from A to F. To win an A, fund companies must act in the interest of shareholders by charging low fees and avoiding running afoul of the SEC. Companies must provide portfolio managers with incentives to act responsibly.

Morningstar prefers compensation systems that base manager pay on long-term performance --not short-term gains. In addition, funds can win high marks when managers invest in their own funds. Morningstar figures that managers who have their own money on the line are more likely to produce good results for shareholders.
1 of 2

Check Out Our Best Services for Investors

Action Alerts PLUS

Portfolio Manager Jim Cramer and Director of Research Jack Mohr reveal their investment tactics while giving advanced notice before every trade.

Product Features:
  • $2.5+ million portfolio
  • Large-cap and dividend focus
  • Intraday trade alerts from Cramer
Quant Ratings

Access the tool that DOMINATES the Russell 2000 and the S&P 500.

Product Features:
  • Buy, hold, or sell recommendations for over 4,300 stocks
  • Unlimited research reports on your favorite stocks
  • A custom stock screener
Stocks Under $10

David Peltier uncovers low dollar stocks with serious upside potential that are flying under Wall Street's radar.

Product Features:
  • Model portfolio
  • Stocks trading below $10
  • Intraday trade alerts
14-Days Free
Only $9.95
14-Days Free
Dividend Stock Advisor

David Peltier identifies the best of breed dividend stocks that will pay a reliable AND significant income stream.

Product Features:
  • Diversified model portfolio of dividend stocks
  • Updates with exact steps to take - BUY, HOLD, SELL
Trifecta Stocks

Every recommendation goes through 3 layers of intense scrutiny—quantitative, fundamental and technical analysis—to maximize profit potential and minimize risk.

Product Features:
  • Model Portfolio
  • Intra Day Trade alerts
  • Access to Quant Ratings
Real Money

More than 30 investing pros with skin in the game give you actionable insight and investment ideas.

Product Features:
  • Access to Jim Cramer's daily blog
  • Intraday commentary and news
  • Real-time trading forums
Only $49.95
14-Days Free
14-Days Free
MORN $75.79 0.00%
AAPL $94.02 0.00%
FB $104.07 0.00%
GOOG $683.57 0.00%
TSLA $162.60 0.00%


Chart of I:DJI
DOW 16,204.97 -211.61 -1.29%
S&P 500 1,880.05 -35.40 -1.85%
NASDAQ 4,363.1440 -146.4150 -3.25%

Free Reports

Top Rated Stocks Top Rated Funds Top Rated ETFs