Do Fund Ratings Matter?

With thousands of mutual funds to choose from, how are you supposed to find the best one for you?

The Investment Company Institute estimates that more than 16,000 mutual funds are available to investors. With choices ranging from the tiny long-short Nakoma Absolute Return Fund (NARFX) to the $100 billion Vanguard Prime Money Market Fund (VMMXX), there's something to meet nearly every need. Yet so many choices can paralyze investors.

Two services that sort through the pile, Morningstar (Nasdaq: MORN  ) and Lipper, provide third-party analysis. However, investors shouldn't just blindly follow their advice.

How rankings work
Both Morningstar and Lipper have a ranking system that breaks mutual funds into one of five groups, but the companies get to their groupings in different ways.

Morningstar
This service rates funds within categories, such as small-cap growth or large-cap value. The ratings go from one to five stars, according to a fund's risk-adjusted return, after accounting for sales charges and expenses. Morningstar measures risk by looking at how much share prices move, with down moves exacting a higher weight. Stars are assigned such that the distribution reflects a classic bell-shaped curve, with the largest number of funds getting three stars. Only the top 10% of funds in each category get five stars, and the bottom 10% garner just one.

Lipper
Lipper also has a 1-to-5 ranking system. But in contrast with Morningstar, Lipper ranks funds so that each category has an equal percentage of each peer group in each category. This means that the top 20% of funds receive a "5" rating and the bottom 20% get a "1." Funds are ranked against their peer group using four measurements: total return, consistent return, preservation, and expenses. In the U.S., a fifth measurement, tax efficiency, is also included in the ranking process.

Since each of the two services rates funds against the peers in their category, it's important not to mix categories if you're trying to compare funds. A small-cap fund and a single-country fund, each with a three-star ranking, isn't really an apples-to-apples comparison, since the funds are from different categories.

Predictive performance?
Lipper and Morningstar provide investors a context and perspective for making informed investment decisions. However, just because a fund has a high ranking, that doesn't always mean it has superior future performance in store. So I tend to give mutual fund rankings relatively little consideration when buying a fund.

Instead, I'd recommend using the various mutual fund ranking services as an initial starting point and then consider additional factors to create a portfolio tailored to your needs and circumstances.

Things to consider
Some additional factors to consider include the diversification of a fund and how that differs from the rest of the funds in its category. A less diversified and highly focused fund will shine when the sector is doing well but may suffer steeper declines than a more diversified fund when the sector loses its luster. Be wary of a fund that has experienced rapid growth, too, since the assets may become too large for the manager to effectively deploy in profitable investments.

Long-term successful fund management is a positive feature, and longevity itself can be an indication of success. The portfolio manager of the Royce Pennsylvania Mutual Fund (PENNX), Charles M. Royce, has been a part of the fund's management team for more than 35 years. During the past decade, Royce has guided the fund to a benchmark-beating 13% average annual return with holdings such as Alliance Bernstein (NYSE: AB  ) , Unit Corp. (NYSE: UNT  ) , and Lincoln Electric (Nasdaq: LECO  ) .

Yet even the best managers have down periods. Ken Heebner's CGM Focus Fund (CGMFX), for example, has experienced periods when the fund was down -- but performance has later come roaring back. Top holdings for CGM Focus in mid-2008 included Freeport-McMoRan Copper & Gold (NYSE: FCX  ) , U.S. Steel (NYSE: X  ) , and Devon Energy (NYSE: DVN  ) .

Finally, make sure you're comfortable with the risk of the fund and that it fits your preferences. It makes little sense to buy into a mutual fund with a rollercoaster performance if the ups and downs leave you too sick to enjoy the monetary gains.

Future forecasting
The boilerplate warning that "past performance is no indication of future performance" is well worth heeding when it comes to mutual fund ratings. Mutual fund data is available for those willing to put in some work, but with so many choices, this task is not always easy.

Lipper and Morningstar can help narrow the field for investors. But don't foolishly follow their ratings without doing some work on your own, if you want to get the best fit for your portfolio.

Related Foolishness:

Want help finding the perfect fund? Learn more about mutual funds and ETFs with the Fool's Champion Funds newsletter service. A free 30-day trial includes plenty of fund recommendations and will start you on the road to investing success.

Fool contributor Zoe Van Schyndel lives in the Seattle area, where she enjoys the coffee and natural wonders. She owns none of the funds or securities mentioned in this article. Alliance Bernstein is a Motley Fool Income Investor recommendation. Unit Corp. and Morningstar are Motley Fool Stock Advisor picks. The Fool owns shares of Morningstar. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.


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