Do Third-Party Ratings Really Matter?

If your fund receives a low third-party rating, you might consider it bad news. But the good news is that as long as you’ve selected a fund that meets your specific investment objectives, third-party ratings may not matter.

Morningstar is one of the much-followed mutual fund rating companies. It uses a risk-adjusted formula based on performance over the last three, five and ten years to rate mutual funds. The funds are rated on a one-star (lowest) to five-star (highest) scale. Ratings are assigned on a curve: 10 percent of funds receive five stars; 22.5 percent receive four; 35 percent, three stars; 22.5 percent, two and 10 percent of funds receive a single star.

While ratings can be a valuable part of the mutual fund analysis process, many investors use the number of stars a fund receives as the main criteria for gauging its performance. This may not be wise; you may not realize it, but not every fund has an equal chance of receiving a high rating.

Ratings are assigned over an entire ratings category. In many ratings categories, however, there are different asset classes, such as small-cap funds and large-cap funds. At any given time, one of those asset classes is likely to be performing better than another. As a result, funds in asset classes that are performing well overall are more likely to be highly rated.

Past performance doesn’t guarantee success

As well, past performance does not guarantee future success. As the research company Financial Research Corporation discovered through a data-ranking process, one year’s top performers are no more likely to deliver superior returns the following year than are the year’s worst performers, calling third-party rating systems into question.

Truth is, no third-party system can begin to replace the analysis conducted by you and your advisor in defining your specific investment objectives and building a portfolio that meets those objectives.