Jason Zweig on Morningstar Star Ratings
Over the past months, my articles on Seeking Alpha have received a number of comments reflecting the debate about the reliability of Morningstar’s star ratings as tool for analyzing a fund’s likely performance.
This debate is best summarized in the following quote from commentary by Jason Zweig in which he points out the reasons why more winning mutual funds don’t stay winners.
“A leading investment research firm, Morningstar, awards ‘star ratings’ to funds based on how much risk they took to earn their returns (one star is the worst, five is the best). But, just like past performance itself, these ratings look back in time; they tell you which funds were the best, not which are going to be winners. Five-star funds have a disconcerting habit of going on to underperform one-star funds. […]
“Finally, look at past performance, remembering that it is only a pale predictor of future returns. As we’ve already seen, yesterday’s winners often become tomorrow’s losers. But researchers have shown that one thing is almost certain: Yesterday’s losers almost never become tomorrow’s winners. So avoid funds with consistently poor past returns—especially if they have above-average annual expenses.”
(Jason Zweig, Commentary on Chapter 9 of The Intelligent Investor by Benjamin Graham, 2003 Revised Edition, page 252).
While the debate centers on mutual funds, one must similarly question whether Morningstar ratings are a good indicator for closed-end funds (CEFs). As with any other type of fund, “star ratings” for CEFs are only pale predictors of future returns. But… honestly, it couldn’t be otherwise: is there anything in life reliably predictive of the future?
So, let’s consider a Morningstar rating for what it is: “a purely mathematical measure that shows how well a fund’s past returns have compensated shareholders for the amount of risk
