The Risks of Buying Only 5 Star Funds

5-Star Mutual Funds: Should You Buy Them? The Answer May Surprise You!

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Are you looking for the best 5-star funds to buy? Searching for the highest rated mutual funds can be a good way to begin your search but don't limit it to just 5 star funds. The star rating isn't always the best predictor of future performance. Sometimes, 3- and 4-star funds can be smart choices.

Should you invest only in 5-star funds? Before answering this question in detail, let's learn more about the star rating and how it works.

What Is the Star Rating for MutualĀ Funds?

When you hear or read about 5-star funds, the general reference is to Morningstar, Inc, which researches and analyzes mutual funds, exchange-traded funds (ETFs) and stocks. Morningstar is an investment research firm that rose to prominence in the mutual fund world in large part due to its star rating.

In Morningstar's words, here's how their star rating works:

Morningstar rates mutual funds and ETFs from 1 to 5 stars based on how well they've performed (after adjusting for risk and accounting for sales charges) in comparison to similar funds and ETFs.
Within each Morningstar Category, the top 10% of funds and ETFs receive 5 stars and the bottom 10% receive 1 star. Funds and ETFs are rated for up to three time periods-three-, five-, and 10-years and these ratings are combined to produce an overall rating. Funds and ETFs with less than three years of history are not rated.
Ratings are objective, based entirely on a mathematical evaluation of past performance. They're a useful tool for identifying funds and ETFs worthy of further research, but shouldn't be considered buy or sell signals.

In translation, Morningstar rates mutual funds and ETFs based on performance but makes further adjustments for risk. For example, a mutual fund that has performed above average in its category for 3-, 5-, and 10-year returns would likely receive a 5-star rating, especially if the fund achieved those returns without taking an unusually high level of risk compared to other funds in the same category.

So who wouldn't want to buy 5-star funds that get high returns, relative to their respective category, without taking higher risk than average for the category?

When 5-Star Funds Don't Perform As Expected

To be fair, Morningstar doesn't guarantee that future returns will look like past performance, nor do they promise that the 5-star funds will beat the 1-, 2-, 3-, and 4-star funds in the future. However, Morningstar does continue to make their star rating a prominent feature of using their services.

Here are a few observations about the star rating we've made in the 20 years since we've used Morningstar (yes, we still think Morningstar is useful):

  • Arguably, index funds are the best mutual funds for all kinds of investors, from beginners to the experienced, to professionals. But index funds rarely receive a 5-star rating because their performance rarely surpasses the averages in the short-term. Funds like Vanguard Total Stock Market Index (VTSMX) get a 4-star rating because their returns in the 3- and 5-year periods tend to hover around the median. But the 10-year return often beats the vast majority of category peers. VTSMX gets a 5-star rating in my book but it won't likely ever get one in Morningstar's.
  • Some mutual funds can have long stretches of out-performance, sometimes as long as five years or more, because they benefit from more than just a smart, experienced management team -- mutual funds, such as sector funds, can just have good timing from investing in a handfuls of stocks that dominate for a few years. A fund like this can receive a 5-star rating but then those big performers can also have big losses and all of a sudden the 5-star fund turns into a 3-star fund.
  • The star rating can be a good starting point for mutual fund research and analysis. However, limiting the search to just 5 stars is not a good idea. I wouldn't recommend buying a 1- or 2-star fund but there are plenty of 3- and 4-star funds that have done well in the long run. Again, index funds are an example here.

    To summarize, the star rating can be a starting point for mutual fund research but it should only be one of several factors to analyze. In fact, as long as you are putting diversification and low expenses high on your priority list, you can completely ignore the star rating and still find the best funds for you.

    Disclaimer: The information on this site is provided for discussion purposes only and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.