Do Ratings Really Work?

Wherever you look, you will find various rating systems on mutual funds. Stars, Dollar Signs, Bells, etc. All of these rating systems are meant to help you weed through the thousands of mutual funds to get to the BEST funds. But is there really such a thing?

Some of the most recognized rating systems for the Canadian Mutual Fund industry are Gordon Papes ‘dollar’ sign, Globefund, Bellcharts, Richard Croft’s Manager Value Added, Funddata and even I have my own rating system known as FundFilter.

Does a high rating system really mean it will do better in the future?

Most people certainly think so. A recent study showed that Morningstar, North America’s most recognized rating system for funds, has a tremendous influence on mutual fund sales. If Morningstar gives a five star rating, those funds typically have increased sales as a result. According to Rob Bell, Vice President of Morningstar, “Morningstar ratings may move up to 80% to90% of new fund flows in the U.S.”

One of the biggest problems with rating systems is that they are not predictive in nature. This means they do not tell investors whether these funds will necessarily do better in the future. Rather they tell the consumer how the fund has performed in the past.

“We will not and never will promote that you should go out and buy a fund because it’s got four or five stars,” says Bell. Still, he admits that “people love ratings and think they’re going to be an increasing factor and I think it’s important that they’re used properly.”

A guide rating systems

  1. Don’t just use one rating system. As I have said many times, the investment industry is imperfect. There is no single rating system that works 100% of the time. For those of you that love ratings, check out www.fundlibrary.com. They have developed a rating system that looks at the composite of four different systems in Canada (Morningstar, Funddata, Gordon Pape and Globefund).
  2. Understand how the rating were developed. Too many people put emphasis on the results without knowing how the results were achieved. If you are going to use ratings, take the time to understand how they were developed and what they really mean. It is not the destination but the journey that counts.
  3. Remember past performance is no guarantee of future performance. You have probably heard this disclaimer a thousand times before, but it is really important to understand. Most rating systems have little to no predictive element in them. It is natural to think that the nest performer of the past will be the best performer in the future. Unfortunately, it is not that simple. Just think about it, if it were that simple, we would just continue to buy last years winners knowing that they will be this years winners. For those that bought technology, you know this is far from the truth.
  4. Rating can change very quickly. The best example I can give is the AGF World Companies Fund (Formerly known as the Global Strategy World Companies). A little over a year ago, this fund had the best five-year performance for any global equity fund. At this time, the fund was given top ratings by almost every system. The fund grew rapidly. Today, this same fund has mediocre to poor ratings due to the impact of the technology meltdown. Has this fund really changed in a short period of time? Logically, is now the time to buy? Makes you think doesn’t it?

The bottom line

As an advisor, ratings are a very important part of my life in trying to distinguish between good and bad funds. However, good research goes far beyond just looking for five stars, four dollar signs or an A+. Use rating systems as part of your research, but remember that just because the experts give them top marks, does not mean they will be the best investment in the future. Take the time to understand how the ratings were achieved. This will be the first step to educating yourself about mutual funds.

Written by Jim Yih

Jim Yih is a Fee Only Advisor, Best Selling Author, and Financial Speaker on wealth, retirement and personal finance. Currently, Jim specializes in putting Financial Education programs into the workplace. For more information you can follow him on Twitter @JimYih or visit his other websites JimYih.com and Clearpoint Benefit Solutions.

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