- The Wall Street Journal reports that many investors and financial advisors trust Morningstar's fund-rating system, yet only 12% of five-star funds did well enough to deserve the rating.
- One advisor takes the ratings "with a grain of salt," another notes a decrease in investor interest of late and another forswears the use of fund-rating systems entirely.
- Some advisors agree that many investors still do trust fund-rating systems.
According to a recent article in the Wall Street Journal on research firm Morningstar's star rating system, many investors and their advisors believe that the number of stars assigned to a mutual fund is a good guide to its future performance. Furthermore, the Journal found that investors put new money into five-star-rated funds in 69 percent of the months they held that rating.
Investors' confidence in the ratings as indicators of future performance is misplaced, however. According to the article, "of funds awarded a coveted five-star overall rating, only 12 percent did well enough over the next five years to earn a top rating for that period."
CNBC.com contacted several financial advisors for their reaction to the findings.
"While Morningstar stated it never claimed its star ratings are not preordained to be a 'predictive measure,' many investors and advisors alike consciously drift into the realm of utilizing five-star-rated funds like a cat to catnip," said Jon W. Ulin, certified financial planner and managing principal of Ulin & Co. Wealth Management.
Picking a stock, sector or actively managed mutual fund because it recently outperformed over the past year is a case of hindsight bias and chasing returns, he said.
"Our firm has been utilizing Morningstar as a primary screener for almost two decades, and [we] employ the Morningstar Portfolio snapshot tool in client meetings to illustrate the risks, costs, sector exposure and even global positioning of their entire portfolio, but never discuss the actual ratings on their underlying holdings."
While Morningstar tools can be to used to quickly screen a mutual fund for benchmarking comparisons, it is acutely more challenging to screen for an investment manager's process and philosophy, Ulin added.
For her part, Winnie Sun, managing director and founding partner of Sun Group Wealth Partners, said her firm has always taken Morningstar's ratings "with a grain of salt."
"But with all the skepticism toward our industry, we have found that clients believe and take comfort that there is Morningstar," she added. "To our clients, Morningstar is another reputable rating company out there that they could research and justify their investment choices."
Still, it's a matter of transparency, Sun noted, and "Morningstar is going need to provide us more value to justify the fees so many of us pay to use their tools."
In part because of disappointing results from prior-year five-star funds, Sun's firm has been using more exchange-traded funds in client portfolios, according to Sun.
The relevancy of Morningstar ratings to clients and advisors seems to have declined significantly in recent years, according to Kevin J. Meehan, CFP, regional president at Wealth Enhancement Group.
"I cannot recall a client referencing their ratings in years," he said. "My sense is [that] as the use of indexing has accelerated — and with fewer fund companies getting a larger percentage of industry asset flows — even the do-it-yourselfer is not building portfolios the same way they were before."
It could be argued that the ratings are more harmful than helpful, said Robert Schmansky, CFP, owner of Clear Financial Advisors.
Many funds that collapsed began with high ratings, and they have a significantly greater chance of being shuttered or performing in the bottom tier for the five-year periods after the previous five in the top of the rankings, he said.
More return requires more risk, noted Schmansky. "Over time you have funds encouraged to take on risk in order to show a better result," he said. "For example, a bond fund may borrow and take on leverage in order to show a higher return but has significantly higher risk than a retiree may want in an income portfolio."
Funds have been, and continue to be, mischaracterized, Schmansky added. "They did provide some value in that the ratings gave us some truths about investing," he said. "A frequent correlation is that between low fees and high results."
Expenses matter, agreed Kevin M. Gahagan, CFP, principal and chief investment officer of Mosaic Financial Partners.
"The only metric that has been shown to have some degree of predictive ability is low fund expense," he said. "There is a reasonably consistent result that within any asset class or fund category, those funds with the lowest expenses will tend to outperform over time.
"This is one of the primary reasons that low-cost index funds tend to achieve top-quartile performance over time."
Mark G. Smith, CFP, president of Vision Wealth Planning, was not surprised by the article's findings. "It doesn't change my thinking whatsoever about Morningstar ratings," he said. "I have never used that information to make any type of recommendation, and find that information like this is fairly useless in my daily work."
Smith referenced a quote from Vanguard's Jack Bogle, in which he described the stock market as "a giant distraction" to the business of investing.
"I think Morningstar ratings fall into that definition of giant distraction," Smith said. "They give investors comfort, but comfort doesn't have anything to do with the predictability of future returns."
In fact, the opposite is often true when it comes to investing, he added. "I'm glad to see mainstream media deal with an important investor issue such as this to hopefully bring attention back to the basic tenets of investing instead of relying on ratings that really mean nothing."
— By Deborah Nason, special to CNBC.com