Anyone who has invested in mutual funds should be familiar with the phrase, “Past performance is no guarantee of future results.” Yet for years, many individual investors have largely ignored this advice by basing their mutual fund selections in part or entirely upon a “star” rating system that focuses heavily on past performance.
Introduced years ago by Morningstar, the star system is so in tune with the average investor’s tendency to chase performance that some studies suggest that the bulk of assets flowing into mutual funds ends up in funds with a four- or five-star rating. This occurs despite the fact that past performance — and those ubiquitous star ratings — have historically had little correlation to future performance.
So, last month, when Morningstar tacitly acknowledged the limitations of its star system in announcing that they’d developed a new, forward-looking methodology called “Analyst Rating” to evaluate funds, FFSA members asked for my opinion.
I’d give the firm a B for effort, but for Vanguard investors, I don’t think the system is going to help much. Let me explain why.
Intended to supplement the star system, which the firm will continue to use, Analyst Ratings will focus less on past performance (or underperformance) and rely upon the analysis and opinions of Morningstar’s analysts.
According to Morningstar, the new ratings, which will start rolling out in the fall, will be based on five P’s:
1. People (quality of the management of the fund)
2. Process (a fund’s objective and how closely it’s followed)
3. Parent (quality of the fund family behind the fund)
4. Performance (long-term results and consistency throughout market cycles)
5. Price (expenses and fees)
If you think you’ve heard this before, well, you have. Jack Bogle, Vanguard’s founder, laid out his “Four P’s” for choosing good fund managers in the mid-80s. Bogle’s P’s: Personality (or people), Policies (investment policies), Portfolios (making sure the policies are followed) and Performance. Sound familiar?
Based on how Morningstar’s analysts feel about a fund’s five P’s, they’ll each be rated on a five-part scale, ranging from AAA (best of breed), AA (notable advantages), A (the lowest favorable rating), neutral and negative. In short, the rating will be based on the analyst’s conviction in the fund’s ability to outperform its peer group and/or a relevant benchmark on a risk-adjusted basis over the long term. Expectations are that only 10% to 20% of the funds it rates will earn positive ratings, while 20% will likely receive negative ratings. The majority of funds will be rated “neutral.”
Here’s the rub. I expect my favorite Vanguard funds to score well on low costs (price), “stewardship” (parent) and “process,” as Vanguard’s portfolio oversight group holds managers’ feet to the fire and keep very tight reins on what they can and can’t do. Additionally, since Vanguard outsources portfolio management to other large sub-advisors, I would expect they will earn high “people” and “performance” marks. And don’t forget, the Vanguard funds are created using the same criteria Morningstar is using. That’s a pretty good match. Vanguard’s going to love it.
Like I said, I commend Morningstar for broadening the scope of its research. But I wouldn’t put too much stock in the new analyst ratings. For one thing, it’s hard to view the company as a truly independent arbiter of mutual fund performance. Visitors to Morningstar’s website are greeted by splashy ads from large mutual fund firms touting their own star ratings. Advertisements from other fund firms are scattered across the site. The firm publishes a magazine for financial advisors that features full-page ads from these same mutual fund firms.
While I’m not implying that Morningstar is engaged in any malfeasance, the fact remains that their “independent” business model relies on ad revenues from the very companies they review. And, as a public company, the managers and Board must answer to the shareholders, who, let’s face it, want profits and the higher stock price that goes with it.
I could go on, but suffice to say that there probably won’t be anything in these Analyst Ratings that changes my mind about which Vanguard funds and managers are the best, and which aren’t.