Mutual fund companies love to tout their funds that have achieved a 4 or 5 star rating from Morningstar. And most individual investors use those ratings to help decide which funds to invest their money in. Financial advisors will also often use those ratings to show their clients that they only put them in highly rated investments.
The problem is funds that are the highest rated tend to underperform their benchmark by the largest percentage for the subsequent 36 month period. Vanguard compiled data at the end of 2013 showing that 5-star rated funds underperformed their benchmark by almost 1.4% on an annualized basis. The greatest irony in the rankings is the lower you go on the Morningstar rating, the better the funds performed relative to their benchmark!
Annualized 36-Month Median Fund Performance Relative to Benchmark
Virtually all marketing or advertisements that use a Morningstar rating is accompanied by the disclaimer “Past performance is no guarantee of future results.” Unfortunately, this might be the most frequently ignored disclaimer of all time.
The vast majority of the mutual funds that achieve 4 and 5-star ratings are actively-managed funds, meaning they employ a team of researchers and stock pickers (at very high salaries) to try to beat their respective benchmark. This leads to higher expenses for the fund and higher taxes for the fund shareholders.
The counterpoint to active funds is called passive management, or commonly referred to as indexing. Vanguard and Dimensional Fund Advisors (which Cornerstone Wealth Advisors primarily utilizes) are the two largest providers of this style. These funds rarely top any “Hot Buy” lists, but by having extremely low expenses and minimal taxes to investors, these funds are able to beat the majority of their actively managed counterparts.
If you have questions about your current portfolio, we encourage you to reach out to us and let us show you how a portfolio built using passively managed funds can put you in a better position to reach your long-term financial goals.