The mutual fund industry is crowded and complex. With literally thousands of funds to choose from, it's no wonder investors can become confused.
Helping to sort out that confusion is Morningstar, the ratings agency that dominates the landscape of those monitoring the mutual fund market. Its simple, five-star ratings system has become the gold standard for evaluating mutual funds.
Morningstar uses a formula of long- and short-term performance adjusted for risk and expenses to determine its rankings. Five stars is the highest rating and one star is the lowest.
Additionally, Morningstar has cleverly placed funds into what it calls "style boxes" that slice and dice funds based on size and investment approach. Investors can take the combination of the ratings and style boxes to guide their investment decisions.
It sounds simple, and we should all be thankful that Morningstar has gone through so much effort to sort through such a complex maze for investors.
While there is much good about Morningstar and its rating system, danger lurks in any attempt to make the complex simple.
As everyone should know by now, past performance does not guarantee future success. In fact, one could argue that using past performance to rank funds is a mistake. If anything, a highly rated fund may not be able to sustain the types of returns that made it highly rated in the first place.
Prudent investors may want to lock in gains by selling highly rated funds instead of purchasing more shares, as the high rating would suggest they do.
The flip side is true as well. Investors looking for an edge may wish to consider poorly rated funds -- the idea being that superior performance is just around the corner. Think of it as a contrarian approach.
Mutual funds can perform poorly for any number of reasons, and Morningstar's ranking system does not take out such noise. For example, a mutual fund's style can be out of favor, and the fund's Morningstar rating will drop significantly as a result.
When the investment style comes back in vogue, Morningstar would still have you believing the fund is a dog.
Do you remember how poorly value managers fared in the 1990s, during the technology bubble? The entire industry, including pundits, claimed that the value approach to investing was dead. You could have bought any number of one-star or two-star funds in the category that ultimately performed quite well for the first eight years of the new millennium.
It's also important for investors to understand what it takes to manage money in a complex market. It's a difficult job, and only a small percentage of funds beat the market on a regular basis. It's perfectly plausible for an excellent manager to stumble with one or two bad years. It happens, and when it does, there goes the Morningstar ranking.
If you look at just a ranking, you might jettison a perfectly good fund that is on the brink of a breakout.
As a contrarian, I like the idea of finding the beaten-down stock or fund. The approach has served me well over the years.
Continued: 5 low-rated funds to consider
