5-Star Past, 1-Star Future

Morningstar is renowned by professionals for their research and insights. For us everyday investors, we might recognize their signature 5-star rating system. Big banks love to brag about their stars! But do more stars equal more returns?

The rating is fairly simple. Morningstar groups funds with their peers. Funds that have beaten their peers will get 4 to 5 stars, funds that underperformed will get 1 to 2.

Based purely on historical data, it doesn't do much in predicting the future. Past 5-star performance doesn't equal future 5-star performance.

The Wall Street Journal studied thousands of funds since the star rating's inception (2003-2017) and it was clear that top-performers don't persist. Only 12% of 5-star funds did well enough over the next five years to earn the top rating. 10% of past top funds did so poorly they ended up with an 1-star rating.

This is consistent with SPIVA's findings on persistent performance, top performers from one period are unlikely to keep it up in the next.

The stars are an interesting data point but shouldn't to be used in isolation for investing decisions. Morningstar themselves acknowledge this.

"Because the Star rating is only based on past performance it should not be the sole factor in making an investment decision". - Morningstar

"Advisors" however treat stars like the holy grail. Shoving them in our faces to show how talented their managers are. It's a trick!

Big banks operate hundreds of funds at a time. Through sheer luck alone some are bound to get a 5-star rating. Winners are sold hard, while losers are brushed under the rug. When 5-star funds underperform and move down the scale (as they likely will), the banks will draw your attention to others that have moved up. Rinse and repeat.

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