It seems that if something can be "dumbed down", it will be.  This is particularly true when it comes to mutual fund selection and the results are disturbing.

In an article titled "Stargazing: Five-Star Investors Revisited", Tom McGuigan and Tim Courtney examined 248 mutual funds that were five-star rated by Morningstar as of December 31, 1999.  The findings are very interesting.  As of December 31, 2009, exactly ten years later:

• Only four of the original 248 funds were still five-star rated.
• Of the 248 funds, 87 had ceased to exist.
• Of those still in existence, all had been downgraded to an average of just under three stars.

Not a single small cap value fund was rated five stars in 1999.  Yet, over the next ten years, this asset class proved to be the best performer.  The average return for five-star funds over the ten-year period was worse than the average return for all funds in every category except international stocks.  Even then, the five-star international stocks only beat the average by about a tenth of a percent per year.

Beyond all this, the study found that investors in five-star funds achieved lower rates of return than those that invested in the average fund.  Why?  Probably because they bought them in 1999 and dumped them at a loss when the market turned down over the next few years.

You might find this surprising, but we don't.  We know that fund rating services cannot identify, in advance, funds that will outperform.  We also know that investor behavior is the most important determinant of portfolio performance.

Scott Maxwell recently attended a conference where an insurance firm's investment arm offered advice to their sales force on how to win investment business from prospective clients.  The advice was to comb through the prospect's portfolio and look for funds that had one or two-star ratings.  Then, ask the prospect why he or she would do business with an advisor who obviously can't count stars.  When Scott pointed out that the ratings had no correlation with future performance, he was pointedly reminded that this was about winning business and not about what's best for the client. 

The selection of a fund should be based on the fund's statistical contribution to the portfolio.  In his recent article, "Stars or Straws", DFA's Jim Parker discusses the foundation for choosing one fund over another.  "Leading academics Gene Fama and Ken French, in a recent study of mutual fund performance, showed how hard it is for investors to distinguish skill from pure chance in analysing the returns of individual funds.

So what should an investor and his or her advisor weigh up in making a decision? The key here is to focus on items within their control, such as:

• Are the risks being taken related to return?
• Are those risks targeted in a reliable, consistent way?
• How diversified is the fund?
• Does it make promises it can't keep?
• What is more important - individual judgement or clear processes?
• Are the underlying strategies driven by forecasts?
• Does the fund take account of costs and taxes in its decisions?
• Does the fund manager communicate in a clear and consistent way?

While many of these attributes can lead to good outcomes for investors, they are no guarantee of positive returns every year. Anyone who makes those sorts of promises risks disillusioning those who put their faith in them.

But the above characteristics can give investors comfort that their money is being invested in a consistent, transparent way and that ensures that when the targeted premiums kick in, they are positioned to receive them."