Anybody who knows me knows that I'm a checker of reviews and ratings. If I hear about a book or movie that sounds interesting, I'll look up more information on it before deciding to see or read it. If I need a new toilet, even though I may be impressed by American Standard's Champion -- which can evacuate 29 golf balls in a single flush -- I'll still check to see which models Consumer Reports recommends.
So, it's not surprising that on occasion, when I find myself at the Morningstar website looking up some esoteric information on a mutual fund, I find myself swayed by funds that have earned five-star ratings.
An interesting recent article has tempered my enthusiasm, though. Penned by Morningstar's own director of mutual fund research, Russel Kinnel, it candidly explained that the quantitative nature of Morningstar's rating system invariably includes some duds on occasion, and "therefore does not serve as a substitute for fundamental research."
Consider this scenario, for example. A fund invests heavily in some sector or nook, such as energy stocks or emerging markets. If that area has been on fire recently, the fund might have achieved amazing results in the recent past, making it look better in the eyes of the star-rating system. But hot areas inevitably cool off.
Similarly, a terrific fund might lose its top manager or managers. It won't show up in the ranking, but there are few changes more significant for a fund than the loss of its leadership.
As one example of an overrated fund, Kinnel pointed out the five-star Jacob Internet Fund, saying:
This fund is a classic example of the quirkiness caused by the time periods that factor into the star rating. Investors who bought at inception are still about 70% in the hole, yet this fund still has five stars because its horrific bear-market losses are starting to roll off the five-year record. The fund's 79% loss in 2000 isn't there, and its 56% loss in 2001 is starting to fade.
Kinnel also cited its very high expense ratio (annual fee) of 2.64% and its "unimpressive manager."
In the fund's defense, I'll point out that its past few years of returns aren't so shabby: 101% in 2003, 32% in 2004, and 10.8% in 2005. Still, there are less risky ways to make money in mutual funds. (The fund's top holdings recently included Baidu.com
Go beyond numbers
It's easy and tempting to find promising investments simply by running quantitative screens. For example, I looked up S&P 500 component companies with profit margins of at least 20% and betas of no more than 1. That should give me stable, high-profit firms, right? Well, it will. The screen turned up Citigroup
Screens are handy, but they only look at some factors and leave out many others. Invest based on screening results, and you may regret it.
Look at the big picture
So, when you're prowling for stocks or funds, make sure you look at a lot of factors, not just a few. Focus on both the quality of the company (including profit margins, revenue and earnings growth, return on assets and equity, free cash flow, and competitive strengths) and on the stock's price (including the P/E ratio, market capitalization, and discounted cash flow analysis). Include qualitative factors as much as possible, too, such as the quality of management. With mutual funds, assess the long-term track record of the managers, as well as the fund's focus, its fees, and its communications to the public.
That's what Shannon Zimmerman does. He seeks out terrific funds with outstanding managers and reasonable fees before recommending them for our Motley Fool Champion Funds newsletter. Try it for free to see which funds he's recommended -- and why. Together, his picks have outpaced their benchmarks' returns, gaining an average of 21% versus 14%.
Learn much more in these articles by Shannon:
This article was originally published on June 2, 2006. It has been updated.