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Should You Buy a 5-Star Fund?

Welcome back to another edition of Foolish mutual fund basics. This time, we're leaving behind the taxing world of portfolio turnover for the tony tidings of fund raters. Ready to get started? Good.

What it is
Ratings agencies analyze funds in the same way that brokers judge stocks. The most well-known fund aficionados are Standard & Poor's, Lipper, Consumer Reports, and, of course, Morningstar (Nasdaq: MORN  ) .

Each of these firms, except for Consumer Reports, which is owned by the non-profit Consumers Union, is in the business of making money by selling data, usually to brokers or advisors who sell funds to clients. But their secret sauce is shorthand; each rater claims a unique and easily understandable process by which they single out the best funds.

Take Morningstar. In the 1980s it pioneered the five-star rating system. The theory -- according to Morningstar, at least -- is that the more stars a fund has, the more likely it is to be worth your investing dollars. Certainly, data backs up the idea that, on the whole, five-star funds outperform four-star funds, which outperform three-star funds, and so on.

Still, Shannon Zimmerman, who co-advises Motley Fool GreenLight and leads our Champion Funds service, isn't so sure of the system: "... helpful though they can be, these ratings are purely quantitative, backward-looking measures. To the extent that the manager who earned the marks isn't still calling the shots, they're not very useful when it comes to gauging a fund's forward-looking prospects."

How it works
What's more, the Morningstar rating won't tell you whether a fund is a market-beater. That's not all that helpful for the fund investor whose main interest is to slap the smile off the face of the S&P 500.

But don't take my word for it. Let's run through an example. Chase Growth (FUND: CHASX  ) is a five-star fund that Morningstar says owns big stakes in Bank of America (NYSE: BAC  ) , Lockheed Martin (NYSE: LMT  ) , PepsiCo (NYSE: PEP  ) , Wells Fargo (NYSE: WFC  ) , and Oracle (Nasdaq: ORCL  ) . And yet the fund has lost badly -- by more than 11% -- to the S&P this year and is down more than 1% annually versus the bogey over the past three years.

Go under the hood
Fortunately, it's pretty easy to determine whether a fund's five stars translate into all-star status. Start by looking into whether the manager leading the fund has been at the helm throughout its best years. Then, make sure the fund charges less than peers for better results. And finally, check for a long-term record of market-beating performance in the same category.

Most all of this data is available at Morningstar. Let's run through an example by way of checking up on one of Shannon's better picks, the Royce Premier fund. Enter the ticker "RYPRX" at the home page. Once there, you'll see that manager Charles Royce has been on the job since 1991.

Second, check out the expense ratio. Premier charges just 1.13% a year in management fees with no loads, which is a nice discount to the 1.47% category average.

Finally, click the "total returns" tab. There, you'll see that over the last three-, five-, and 10-year periods Royce has led Premier past the S&P by more than 5% annually. Add it all up and this appears to be a superior fund run by a championship manager.

Follow the money
Star ratings may seem to offer an excellent shortcut for the time-challenged investor. Sometimes that's true, but not often enough. Don't let yourself be lulled into a deceptively poor fund; do your homework instead. Check up on the manager, his record, and his fees before you invest. That's the Foolish way to get the most from your fund portfolio.

Interested in more moneymaking tips? Consider GreenLight. Shannon and co-advisor Dayana Yochim are offering 30 days of free access to the service right now.

Fool contributor Tim Beyers, ranked 1,309 out of 13,830 in Motley Fool CAPS, rarely sells his stocks or his funds. Tim didn't own shares in any of the companies mentioned in this article at the time of publication. Get a peek at everything he's invested in by checking Tim's Fool profile. Bank of America is an Income Investor recommendation. The Motley Fool's disclosure policy is a bargain at any price.

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