The Risks of Buying Only 5 Star Funds

Why a 5-star rating doesn't mean you're getting the best fund

mutual fund analysis - 5 star rating
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Are you looking for the best 5-star funds you can find? Searching for the highest rated funds is not the worst way to begin your quest to buy the best funds. But the number of a mutual fund's stars can at times have about the same predictive value as an astrologist's reading of the celestial stars in the sky.

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 mutual fFunds?

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:

The Morningstar Rating is based on Morningstar Risk Adjusted Return. Morningstar calculates ratings for the three-, five-, and 10-year periods, and then the Overall Morningstar Rating is based on a weighted average of the available time-period ratings. The following items are needed to calculate the Morningstar Rating for funds:
Morningstar Risk-Adjusted Return% Rank for funds in a category for three, five, and 10 years.
Historical category assignments for all funds in the sample
A table that describes the degree of similarity between any two pairs of categories, ranging from zero (highly dissimilar) to one (identical)

In translation, Morningstar rates mutual funds 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.

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 will never 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 get one in Morningstar's.
  • Some mutual funds can have long stretches of outperformance, 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 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.