Tip: Don't Judge a Mutual Fund by it's Rating

The first thing I did when I started gaining interest in mutual funds was Google the top funds in Canada.  I arrived at the Globe and Mail 5-star Report on mutual funds and immediately thought to myself how easy it would be to choose a successful investment; just look at the rating and pick the best one.

Good thing I decided to save money and read a few books before I invested in something.

A 5-star rating does not predict success

In fact, in 2004 Mark Hulbert wrote in Forbes Magazine stating that the average growth of the top funds on Morningstar in the past decade was 5.7%, compared to 10.3% for the Wilshire 5000 Index Fund.

Additionally, a study by Barksdale and Green on 144 institutional equity portfolios from 1975 to 1989 found that the portfolios that finished in the top 20% in the first five years were the least likely to finish in the top half in the last five years.

Morningstar even states on their website that these ratings shouldn’t be used to predict future performance.

So why do these ratings even exist?

Because people believe them.  Although the government requires by law that a statement must be made about the lack of correlation between ratings and future performance, the 5-star funds are still advertised like buying into them provides guaranteed returns.

I’m not saying that these ratings don’t provide any useful information. The Globe and Mail website states that historically, on average, their top rated funds do better than the others over a six month to two year period.  Whether you want to believe that or not is up to you; what is important to remember is that it if you are going to take the rating into account, it should not be the only, or even the major, indicator of performance that you consider.  Instead, factors that influence cost, such as the expense ratio, can provide real information about what will happen to the money you invest into a particular fund.

In reality you should never make an investing decision based on one factor, but this is especially true for fund ratings.  Do your homework, read the prospectus, and make wise decisions based on facts with some inherent value.