Star Ratings vs. Expense Ratios: Which Is Better at Predicting Performance
If you had to pick, which do you think would better predict the future performance of mutual funds:
(A) The Morningstar Star Rating
(B) The expense ratio of the fund
Most investors would likely choose “A”. According to Morningstar, “The star rating is a measure of risk- and load-adjusted returns”. The star ratings are well known, funds regularly advertise when their fund has a four or five-star rating. See Wasatch Frontier Emerging Small Countries Fund Achieves 5-Star Rating From Morningstar.
When blending risk, generally measured as the variability of historical returns, and performance, the rate of return earned by a fund over time, generally you are able to see which managers most efficiently performed. If two funds had a ten percent return for a five year period but fund A had double the variability of fund B, you would generally want to invest with fund B. The more the risk a fund exhibits, the higher the return you would expect, or perhaps hope, to receive. The surprising answer to the question above, only made more surprising by the fact that Morningstar itself published the research, is that having a lower expense ratio was a more accurate predictive measure of performance. The study, which was released in 2010, only further adds fuel to the active vs. passive wave, see primer on active vs. passive management, and further question the value of choosing higher fee active funds.
However, this answer shouldn’t be too shocking. After all, how many times have we read or heard in an audio advertisement that “past performance is no guarantee of future results”. In fact, in the press release linked above, Wasatch disclaims the same after championing the accomplishment of receiving the five-star rating.
This research was actually brought to my attention by a tweet from @Wealthfront, a self-proclaimed “robo advisor”. Wealthfront is a proponent of utilizing index funds and passive investment strategies and delivers its investment services through an automated website, no human interaction needed. See The Changing Face of Robo Advisors for more on the robo topic.
This information really begs the question, what is the point of advertising Morningstar star ratings? Is press releases like the above misleading? Perhaps mutual funds would be better off advertising loud and clear what their expense ratio is relative to their peers. This kind of advertisement, while a bit strange, would definitely be educational and perhaps the best predictive measure of success!
Marshall Smith CIPM, Chief Product Officer, has been with First Rate since 2006. You can follow Marshall on Twitter @1stRateMarshall, or connect via LinkedIn.