No matter what kind of survey it is, there's nothing like being number one. Sadly, most mutual fund managers and their funds can't claim the top position that "Seinfeld" did for the past several TV seasons. And, fortunately for investors, fund managers don't generally command the fees that Jerry, Elaine, George and Kramer did. It's easy to rate a TV show as not very important (except to the sponsors), but when it comes to rating mutual funds, that's no laughing matter.
So what's the deal with all these fund ratings? I mean, it seems as if everybody is getting into the act. You expect it from publications like Business Week, Forbes, Barron's,Money, and The Wall Street Journal. But when you see a list in Golf Digest, you may find yourself chanting, "Serenity now!" as you pore over the lists. Which list is best? Which company provides the best service? You don't have to wait for Festivus to find out.
Lorayne Fiorillo is a financial advisor and first vice president of investments at Prudential Securities Inc. Past performance is no guarantee of future returns, yadda, yadda, yadda.
Get Out! Of Your Investment Rut
Looking at the fund rankings in popular magazines or newspapers? Many of them use information compiled by Lipper Analytical Services Inc. in Summit, New Jersey. If it's ratings you want, though, you're in the wrong place. "We don't rate mutual funds, we rank them," says Lipper's Melissa Daly. "Rating is sometimes confused with an opinion. You can rate a restaurant or a movie, but in ranking something, you're placing it against its peers."
So how does Lipper rank funds? Daly cites the A-B-C-D-E system used by The Wall Street Journal (compiled from Lipper's information). These letters represent a performance quintile; funds in the "A" category are those that perform in the top 20 percent; "B" denotes the second 20 percent, and so on, down to "E," the bottom 20 percent of funds for a particular time period.
Daly notes that other mutual fund information services use a quartile system. Not that there's anything wrong with that, but in her opinion, it isn't as accurate. With a quartile system, one basis point difference in performance can move a fund from a bottom ranking to a top ranking. Lipper's ranking system, which breaks funds into five tiers, shows investors that managers whose funds fall in either the "A" category or the "E" category are doing something very different from those who fall in the middle quintiles. Daly contends, "It's a lot more difficult to figure this out if you're just dividing your funds into four parts."
No Stars For You
You may not be seeing stars when you look at your fund, but when used properly, Amy Arnott, editor of Morningstar Mutual Funds and Morningstar No-Load Funds, contends that her firm's "star" evaluations are a good starting point for investors who want to order up the right fund.
Unlike Lipper's performance-based ranking system, Morningstar's recipes are based on risk-adjusted performance. The universe of open-end mutual funds is divided into four broad groups: domestic stock funds, international stock funds, taxable bond funds and municipal funds. Star ratings have two parts: the return component and the risk component. Morningstar's return component is a measure of a fund's return relative to its star rating group, adjusted for sales charges. Morningstar's risk component is calculated by judging a fund's performance against that of the 90-day Treasury bill, which is considered to be an almost risk-free investment. While many other calculations go into this formula (we don't want to be responsible for giving away the recipe, but we have it on very good authority that you can find it on http://www.morningstar.net/InfoDesk/InvestFAQ.html, stars are assigned by subtracting a fund's risk score from its return score and then ranking it against funds in the same group. The top 10 percent of funds rated are awarded five stars, the next 22.5 percent receive four stars, the middle 35 percent get three stars, the next 22.5 percent receive two stars, and the bottom 10 percent are awarded a single star. Funds must have at least a three-year track record to be included.
What's the big deal about stars? I mean, you can't eat them, can you? According to Arnott, stars aren't the secret ingredient. Check out a fund's Morningstar rating sheet, and you'll find lots of crucial ingredients: a written fund analysis that discusses how the fund is managed and what investors can expect from management; charts that show fund performance over time and vs. an appropriate index; the "style box," a tool that represents a fund's characteristics in graphic form; and many other components that help investors get a fund's flavor.
All this information is great, but will it help you choose the right fund? "When you're looking at straight total returns, there's no predictive value," says Arnott. "When you look at the top funds over a five-year period, it doesn't tell you about what's coming."
Morningstar's ratings, unlike rankings based solely on performance, give you an idea of what to expect from a fund so you can match it with your goals and risk tolerance. "Risk is more stable over time," Arnott notes. "Even though it's not predictive, what's high risk tends to stay high risk. Funds that have historically provided good returns relative to their levels of risk give you an idea which funds might be worth investing in." Investors can get Morningstar fund updates in print on a two-week cycle, or on CD-ROM with all fund rating changes updated monthly.
But Is It Fund Worthy?
Matthew Muehlbauer, research manager of The Value Line Mutual Fund Survey in New York City, contends that his company's ranking system is the most useful in helping investors find out what's investment-worthy and what isn't. Value Line Publishing Inc. provides two rankings: an overall rank that divides funds into three universes--equity, taxable fixed income and municipal fixed income--and a risk rank that divides funds into equity and bond universes. The risk rank is calculated using the standard deviation of the fund's returns for 36 months in a five-tier system. A ranking of "one" is the least volatile, "five," the most. Unlike Morningstar, Muehlbauer says that Value Line's service shows each fund's developments over the past 22 weeks, plus a methodical analysis of the fund's management and, in many cases, a recommendation describing what kind of investor should consider the fund. "That way," Muehlbauer says, "you won't be recommending a highly volatile small-company fund to your Great-aunt Irma."
Get It Out Of The Vault
Whether you're a "do-it-yourselfer" or you prefer to have help from outside sources when it comes to buying or selling a fund, knowing how fund services work is all for naught if you don't know which one is best. Mark Hulbert, editor of The Hulbert Financial Digest, which has been tracking Morningstar's performance since 1991, notes that as of December 1997, Morningstar's top-ranked no-load equity funds have lagged the stock market by an average of nearly three percentage points annually. Unfortunately, according to Hulbert, Value Line hasn't fared any better: Since 1994, when The Hulbert Financial Digest started tracking the service, Value Line's top-ranked no-load general equity funds lagged the market by an average of nearly four percentage points per year, as of December 1997.
But for every detractor of a particular ranking system, there's someone who supports it unconditionally. So what's the point?
Access to information on mutual fund performance is available in many forms--it's not like all this information on funds is in the vault or anything. I mean, you could sit around with your friends over coffee and probably come to your own conclusions. What rating services provide is a simple way for investors to sort through the immense number of available options to identify a number of investments for further investigation. By understanding the various methods used and their shortcomings, investors can make more informed choices.
While some investors are stimulated by tomes of performance figures, analyses of management styles, star ratings, risk analysis and other technical and not-so-technical sources of information, other people would rather leave it up to the experts. Financial advisors can provide insight into which funds are most suitable for a particular investor and a specific situation. Even if professional recommendations just help narrow the field, they can save you time, effort and money.
Whichever way you choose to go, before your invest, get a copy of the prospectus of any fund you're considering and read it. Management style, fees, sales charges, investment policies and many other important fund facts can be gleaned from this essential document. If you combine this information with whichever types of analysis you prefer, and remember that past performance is not an indication of future returns, there's a good chance you'll increase your ability to make the right choices.
The Hulbert Financial Digest, (703) 683-5905, http://www.hulbertdigest.com
Morningstar Inc., (800) 735-0700, http://www.morningstar.net
Value Line Publishing Inc., (800) 833-0046, http://www.valueline.com