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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.
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