NEW YORK ( TheStreet) -- For the past decade, Standard & Poor's has rated mutual funds, relying heavily on past performance. Funds with the best risk-adjusted returns got the highest grades.S&P recently revised its system. Now the company also considers a fund's potential future performance. It is too soon to tell how reliable the system will be. But S&P's approach is worth watching because it represents an innovative attempt to forecast future performance. All too often, shareholders race to buy funds with the hottest past performance. That happened last year as investors poured into funds specializing in emerging markets and precious metals. But instead of simply chasing performance, you should ask hard questions about why funds performed well in the past and whether they can continue excelling. For its ratings, S&P grades funds on 12 factors. Backward-looking indicators include managers' tenures and funds' three-year returns compared with those of its peers. To assess future prospects, S&P uses its stock-ranking system to size up holdings in fund portfolios. The system awards grades ranging from one to five. Stocks with the most promising growth and price characteristics are rated five and named "strong buy" candidates. Weak stocks are rated one and considered "strong sells." Say you are interested in the BlackRock Equity Dividend Fund ( MRDVX). By checking the S&P report, you can learn that the fund's holdings include five-star rated JPMorgan Chase ( JPM) and the three-star Raytheon ( RTN). S&P says that it has a positive outlook on the BlackRock portfolio and gives the fund its top rating of five stars. Besides assigning a number rating to each stock in a portfolio, S&P also assigns a letter grade. These S&P quality rankings have long been used to indicate the growth and stability of earnings. Among BlackRock's holdings, Exxon Mobil ( XOM) receives the top mark of A-plus, while JPMorgan earns a B-plus. How much weight should you put on the stars? S&P says the stock ratings have a sound track record. During the 23 years ending in July, five-star stocks returned 13% annually, compared to 9.4% for four-star stocks. One-star stocks lost 1.8%, while the S&P 500 returned 6.4%.
While you should never buy a fund based solely on a star rating, there are good reasons to consult the S&P data. Say you are considering a conservative equity fund because of its past performance. If S&P says the names in the portfolio are rock solid, you should have more confidence in your choice. If the analysts turn their thumbs down, you should ask questions about why the portfolio received low marks. Besides assessing individual holdings of funds, S&P evaluates other factors such as expense ratios, portfolio turnover and standard deviation, a measure of risk. For each category, S&P gives one of three ratings: "positive," "neutral" and "negative." Few funds win positive marks for every category. Consider the Mairs & Power Growth Fund ( MPGFX), a five-star fund. While the three-year returns and stock quality have positive ratings, S&P is "neutral" on the standard deviation, suggesting the fund takes an average amount of risk. That could be a fine score for some investors, but those who favor conservative choices may decide to look elsewhere. All in all, the S&P ratings offer a good starting point for investors. Funds that win five stars include the T. Rowe Price Balanced ( RPBAX), Fidelity Low-Priced Stock ( FLPSX) and Meridian Growth ( MERDX) funds. -- Reported by Stan Luxenberg in New York.