New Fund Ratings Could Earn Gold Star

NEW YORK ( TheStreet) -- For decades, Morningstar's ratings have been a powerful force in the mutual fund industry. Funds that win a top five-star rating tend to attract assets, while most funds that receive a lowly one star soon go out of business.

Fund companies with high grades are quick to mention them in advertisements. But academic studies have shown that the ratings don't necessarily provide reliable guidance. All too often, funds that won top grades have gone on to deliver mediocre results.

Now, Morningstar has developed a new ranking system that will rate recommended funds as gold, silver or bronze. Should you ignore the new system? Not necessarily. There are good reasons to think that the latest approach could be a helpful predictor of future performance.

Old vs. New

The old star system rates funds on their risk-adjusted past performance. Funds in the top 10% of their categories win the top grade of five stars. Performers in the bottom 10% receive one star.

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The approach has some clear flaws. First, it relies solely on past performance. And as the boilerplate warnings state, past performance does not guarantee future results. In addition, the star system is purely mechanical and does not adjust for any changes in a fund's management. Say a fund wins a five-star rating in the large value category. Now the veteran manager quits and is replaced by a novice who buys only small growth stocks. Even though the outlook for the fund has changed, it will still carry the old star ratings.

To its credit Morningstar has warned against relying solely on the stars. The company has often said that past performance should only be one factor that investors consider. Describing the new gold ratings, Morningstar has again warned against relying on the system exclusively. Still, the latest ratings represent a gamble. With the forward-looking ratings, Morningstar intends to pick funds that will outperform their categories. If the system fails, then the company will have egg on its face.

What distinguishes the new approach is that it relies on the subjective judgment of the Morningstar analysts. To determine grades, the analysts must assess the quality of portfolio managers and predict future performance. Funds get top marks for having experienced managers with consistent investment disciplines. Past performance counts, but it is only one of a number of factors. The analysts prefer funds with low fees. By the end of this year, Morningstar plans to rate 1,500 funds.

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