Do Those Five-Star Mutual Funds Really Shine?

A recent issue of Business Week points out the fact that Chicago based Morningstar has enjoyed popularity over the years thanks in part to its one-to-five star mutual fund ratings. Now, however, new research is questioning the value of those ratings.

Finance professor Matthew Morey at Pace University reviewed the performance of diversified U.S. equity funds in the three years before and after they first received the coveted five stars. Once the funds are adjusted for risk, they outperformed the Standard & Poor's 500-stock index on average by 0.36% a month in the three years before they earned top honors and then trailed by 0.41% a month afterward.

Why the falloff in performance? One reason, says Morey, is that money suddenly pouring into the five-star funds overwhelms the manager's ability to invest it. "People think these stars are like the ratings of a movie," he adds. "But a mutual fund isn't the same, and it doesn't maintain its quality."

Morningstar, which revised its ratings criteria two years ago, says its own study shows slightly better performance for five-star funds since the changes. It also warns investors not to invest in mutual funds solely by the stars.

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