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) 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.
The grades have demonstrated some predictive power. Fully 99% of the funds that won A grades in 2004 still exist today, while one third of F-rated funds disappeared. Of funds that won A grades in 2007, 87% went on to equal or exceed the risk-adjusted returns of their peers in the next three years. Only 66% of B-rated funds passed the test. Fund companies that won A grades include American Funds, Clipper, and Dodge & Cox. The data on manager investments is especially noteworthy. The more money that managers invest in their own portfolios, the better the funds perform. Managers who invest more than $1 million delivered significantly better risk-adjusted returns than funds where the managers invested nothing. To find detailed information on a manager's investments, consult the statements of additional information, which are available on many fund company websites. For years, academic researchers have found that the best single predictor is the expense ratio. On average, funds with low costs outperform expensive competitors. Morningstar's research confirmed this. John Rekethaler says that you can improve the odds of success by picking funds that have both top star ratings and low fees. When all of a fund's signs are positive, then there is a good reason to invest. To make use of the data, you might start by looking for funds with top stewardship grades and at least three stars. After locating the candidates, then you must go on to make judgments about whether the funds fit your needs and risk tolerance. Funds that have both A grades and five stars are truly worth considering. Such top funds usually have proven managers with reasonable fees. Among the select group are Oakmark Global ( OAKGX), T. Rowe Price New American Growth ( PRWAX) and Vanguard Wellington ( VWELX).