Don't Put Too Much Stock in Mutual Fund Ratings

Many investors put a lot of faith in mutual fund ratings. However, you may want to consider looking at other sources of information before you invest in a mutual fund. Here are a few reasons that you might not want to put much stock in mutual fund ratings.

Number of Mutual Funds

One of the major reasons to reconsider the significance of mutual fund ratings is that a large number of funds receive a good rating. MorningStar is the most popular mutual fund rating system in the market today. It is important that you understand how MorningStar comes up with these ratings in order to understand their relative importance to mutual fund performance.

First of all, MorningStar looks at the performance of all of the different funds over a certain period of time. Then it looks at how much risk was involved in attaining that rate of return and how risky the funds' strategies were. At that point, all of the different funds are broken down into about 80 different categories. Within each category, MorningStar ranks all the funds from first to last. All of the funds in the top 10 percent of their category receive a five-star rating. The next 22.5 percent of funds receive a four-star rating. When you consider this, you will realize that that means a third of all funds available in the market have a four- or five-star rating. Many investors simply choose four- and five-star funds for their investments. When you realize how large a percentage of funds are in these classes, the significance of the ratings diminishes. You still have a number of funds from which to choose, and not all of them will do well. They are rated on past performance, which is no guarantee for what they will do the future.

Categorization

Another inherent problem with the way that mutual funds are rated is the way they are categorized. Each mutual fund uses its own strategies to invest in different securities. While some funds may be similar, others could be completely different from anything else on the market. However, MorningStar still puts every one into some kind of category.

This means that certain funds that do not easily fit into any group are nevertheless each thrown into a category and evaluated against the other funds. When compared to mutual funds that are not similar, a given fund may not stack up as well as it could. Consequently, it may not receive a good rating. However, if it had been categorized into a different group, it may have received a five-star rating. This means that you should not put much emphasis on these ratings when choosing your investments.

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