Movie-goers know that glowing reviews and plentiful box-office revenues
are no guarantee of a film's greatness. When the movie ends, they are
sometimes left wondering what prompted all the hype.
Savvy investors understand that the same is true with their mutual fund
choices. Picking a fund based on how many stars are hung on its past
performance can leave them with the same empty feeling when they see
actual results.
Fund ratings, in many cases, are a poor basis for decision-making. They
are eye-catching and powerful marketing tools, but no rating system can
accurately predict the future success or failure of a fund. The same
uncertainty applies to both a five-star highflier or a stagnant one-star
dog.
Multiple-star ratings may carry an aura of superiority, achievement and
peace of mind, but statistics continually show, and FINRA regulations
stipulate, that past performance is no indicator of future results.
Russell believes that investors should pay more attention to the stars
within their funds. In our own multi-manager investment approach, the
stars are the money managers that made the cut in Russell's extensive
research process. No matter which asset class or style is in favor at
any given time, Russell's complementary blending of managers is meant to
manage risk and help provide more consistent returns through all kinds
of market environments.
Investors also should look carefully at what drives performance ratings.
For example, in order to place in the top 10% of a fund
category—earning Morningstar's five-star rating—a fund manager
often must take on high levels of risk. That risk is often inappropriate
for many investors, and is likely to land the fund among the bottom
performers the following year.
Consider this nugget from the March 2001 issue of Kiplinger's: Stock
funds that began 2000 with Morningstar's five-star ranking lost 17%, on
average, last year. Funds that began the year with one star gained 5%.
Russell's approach looks past the starred performance to select and
combine managers who have historically performed better on average on a
consistent basis.
"In all fairness to Morningstar, they've never indicated that their star
rankings were predictive of future performance," said Ernie Ankrim,
Russell's Director of Portfolio Research. "But, can people that do
portfolio selection by star ratings expect to do better than a more
informed process like we have at Russell? Based on our research, I find
the results are no."
Nonetheless, the Financial Research Corporation found that a strong
majority of newly invested money in 2000 went into mutual funds which
had garnered four- and five-star ratings, while one- and two-star funds
saw cash outflows.
But attracting cash flow certainly doesn't mean the four- and five-star
funds will develop staying power.
According to Mutual Funds magazine's March 2001 issue, "In 1999,
92% of all tech funds had five-star ratings." Of course, the tech wreck
of 2000 turned many of those into lower-rated funds.
Russell promotes looking past the starred attractions and their
volatility to focus instead on a forward-looking philosophy directed at
long-term competitive returns.
"We make money not by chasing performance, but by seeking consistency,"
Russell CEO Mike Phillips wrote in a January article for Russell.com.
"Not surprisingly, we've found that the less volatile a fund's return,
the less uncertainty for the investor. Our goal—and one that we
have carried out year in and year out—is to provide a stable yet
competitive return."
That doesn't translate to consistent five-star performance but it is
meant to ease the frustration of watching a previously one-star fund
outperform your portfolio of one-time five-star gems.