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Can Morningstar Pick Winning Funds?

NEW YORK ( TheStreet ) -- Morningstar's fund ratings have long carried weight.

Investors flock to mutual funds that earn the top Morningstar grade of five stars.

But this has troubled academic researchers who argue that the star system can only provide limited guidance. The issue is that the ratings rely solely on past performance, and the past doesn't necessarily predict the future, as the boilerplate warnings note.

Morningstar has conceded the point, saying that the stars should only be used by investors as a starting point for research.

Now Morningstar has introduced a new system that rewards top funds with ratings of gold, silver or bronze. Although the old star system simply indicates the funds that had the best returns in the past, the new ratings represent Morningstar's judgment about which funds will be winners in the future.

It is too soon to know whether the latest system can provide reliable guidance, but some of the early results are promising.

For the 12 months ending in May, gold-rated large blend funds returned 28.6%, compared with 27.3% for the S&P 500. Large value winners returned 29.6%, and large growth 29.0%. Top-rated funds in the intermediate-term bond category returned 4.6%, compared with 0.9% for the Barclays Capital U.S. Aggregate bond index.

There is good reason to think that the new system will prove more reliable than the stars. Besides looking at risk-adjusted past performance, the Morningstar analysts now consider a host of factors, including fees and whether fund managers invest in their own portfolios.

The inclusion of fees alone should improve predictions. Many studies have shown that cheap funds outdo expensive ones on average. In addition, Morningstar says that when managers invest heavily in their own funds, they tend to outdo competitors who do not have their nest eggs at stake.

Under the new system, the final grades are partly based on data and partly on the subjective judgments of the analysts. The analysts evaluate whether a fund manager acts in the best interest of shareholders.
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