Fund ratings can mislead investors

Associated Press

NEW YORK — In a nation ruled by its consumers, ratings are counted on to tout and criticize everything from sports-utility vehicles to hotels, from restaurants to, yes, even mutual funds.

But when it comes to fund ratings, experts in the field advise investors not to put too much stock into them.

"You’ve got to be really careful," said Eric Tyson, author of "Mutual Funds for Dummies." "I have seen ratings be significantly misused by many investors."

He explained that often by the time a mutual fund snags certain kudos, its heyday is nearly over. In other words, ratings are a lagging indicator, not an adequate predictor of future performance.

"Ratings can cause people to put their money in overheated sectors and to shun sectors that offer bigger value," Tyson said. "Maybe they have five stars because they are in hot sectors, and hot sectors eventually cool off."

But consumers naturally look to ratings to determine how to spend much of their money and their time, and that means ratings are here to stay.

In fact, Morningstar, the Chicago firm that has been ranking funds since 1986 and is known for its much-coveted five stars, last week announced it was expanding its ratings to include 500 stocks.

According to The Hulbert Financial Digest, ratings can mean much more if investors consider how the rankings themselves stack up.

"We believe that track records are what you look at. The real question is how have the ratings systems done, and that’s how you figure out which ratings systems to follow," said Mark Hulbert, publisher of the digest, which is sold to investors.

Since 1991 when the digest began tracking Morningstar ratings, Hulbert said that the firm’s five-star funds have underperformed the market.

However, financial pros admit that ratings are a good starting point for investors researching funds they might want to buy or sell.

"Sure it is a good signal of, ‘My gosh, you don’t want to have a fund that is two stars year after year.’ That signals that something is wrong," said Peter H. Calfee, a certified financial planner in Cleveland.

The important thing is to understand the rating system itself and the fact that each one works differently, Tyson said.

He said Morningstar is among the best fund rankers because it adjusts its ratings for risk. That means Morningstar takes into consideration how much risk funds undertake, instead of ranking them solely by total return.

While rankings are just the first step in investigating a fund, there’s plenty more investors should consider.

Calfee, the financial planner, recommended mutual fund investors analyze the fund manager’s performance and look up how the fund has done for at least the last five years.

Also, investors should look to see how the fund has performed relative to its benchmark. If a fund, for example, is benchmarked to the Standard &Poor’s 500 index, its performance should ideally surpass the S&P’s performance or at least mirror it.

"If you are going to pay a manager to manage, one would think, ‘Wouldn’t it be nice if they outperformed the benchmark? And, isn’t that why I am paying them?’ "

And don’t take just one ranking to heart. Get second opinions, so to speak.

"I would begin to match up all the various (fund) surveys — for Kiplinger’s, Barron’s, New York Times," Calfee said. "It’s a lot of work."

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