Are Morning Star Ratings really that important?

Question

I'm trying to aid a family member in making some investment decisions. I've placed most of my money in Vanguard mutual funds and they have done pretty well. My family member has a "financial advisor" some of the stocks they picked did really well, others totally poor, when it's all averaged out, my mutual funds did better than the stuff he picked. He's now trying to move some of the assets into funds that generate more dividends ( so this individual can live off them ) .... this much makes sense to me, however when I look at the funds he wants to buy, they have 1 star morning star ratings and also they have not really performed that well over the last 3 or so years. ( although they do pay 6% dividends ). I'm basically wondering why he would choose these and not better rated funds ... I think he is an honest man and a competent professional, I just question his logic a bit

Answer 1

The utility of Morningstar star ratings for predicting future performance is questionable. Morningstar makes no secret of the fact that the ratings reflect past performance; they're not even an attempt to predict future performance. Morningstar itself did a study of how its own star ratings compared to expense ratios as a predictor of fund success. They summarized the results thus:

How often did it pay to heed expense ratios? Every time. How often did it pay to heed the star rating? Most of the time, with a few exceptions. How often did the star rating beat expenses as a predictor? Slightly less than half the time, taking into account funds that expired during the time period.

In other words, Morningstar's own study showed that its own star ratings are not as good at predicting success as simply looking at the expense ratios of the funds.

Now, the study also showed that the star ratings are not totally useless. If you have a choice between two low-expense funds and one has a better Mornigstar rating, that could be something to take into account. However, even there, there is a danger of reversion to the mean: if you buy a five-star fund, you're buying a fund that has done especially well in the recent past, which means that there's a good chance it won't do as well in the future (because that past performance is hard to match). This article by Boglehead Larry Swedroe says:

For four-and five-star equity funds, year-to-year persistence is the equivalent of a coin flip. Less than half of all mutual funds rated four or five-star at year end 1997 still held that high rating at year end 1998. Basically, there is a reversion to a 3-star mean.

In short, you should be very cautious about using Morningstar ratings as a way of deciding what to invest in.

However, this doesn't address the more general question of why your family member's advisor picked the particular funds he did. Maybe he chose them because they had low expense ratios. Maybe he chose them to diversify relative to other investments your family member already has. You can't really start to assess whether those funds were a "good" choice without knowing what the available alternatives are. So basically, the advisor's choices may be reasonable or they may not be, but the Morningstar rating alone doesn't provide much help in deciding that question.