We test the ability of expense ratios and star ratings to predict funds that will survive and beat their peers.
By Russel Kinnel | 08-09-10 | 06:00 AM | Email Article

How Star Ratings Performed
In general, 5-star mutual funds beat 1-star funds on our three measures, although there were exceptions. All told, the stars guided investors to better results in 59 out of 70 (84%) observations.

Russel Kinnel is director of manager research for Morningstar.

In 2005, 5-star domestic-equity funds produced a subsequent return of 2.8% versus 1.6% for 1-star funds. Balanced funds and municipal-bond funds enjoyed a slight edge, but 5-star international funds that survived actually lagged the returns of 1-star funds that survived.

But what happens when you take extinct funds into account for the success ratio? Those star-rating losses turn into victories. The star rating helped investors make better decisions in every example measured by the success ratio.

In that 2005 class, fully 53% of 5-star international equity funds survived and outperformed, whereas a mere 13% of 1-star funds survived and outperformed. How does that jibe with the outperformance of those that survived? Many 1-star funds swung for the fences, and the lucky few that survived enjoyed some strong returns, whereas most 5-star funds survived and outperformed, only less dramatically so. In fact, 5-star funds beat 1-star funds every single time as measured by the success ratio.

When it comes to predicting subsequent star ratings, the rating once again did a respectable job overall, particularly when you consider lousy funds that have been whacked.

Expense Ratios vs. Star Ratings
The expense ratio and the star rating helped investors make better decisions. The star rating and expense ratios were pretty even on the success ratio--the closest thing to a bottom line. By and large, the star ratings from 2005 and 2008 beat expense ratios while expense ratios produced the best success ratios in 2006 and 2007. Overall, expense ratios outdid stars in 23 out of 40 (58%) observations.

For example, in the class of 2005, 5-star balanced funds produced a success ratio of 58% versus 13% for 1-star funds. Meanwhile, the cheapest quintile of balanced funds produced a success ratio of 50%, while the priciest quintile earned a success ratio of 30%. Thus, stars did a better job of separating winners from losers.

Perhaps the most compelling argument for expenses is that they worked every time--because costs always are deducted from returns regardless of the market environment. The star rating, as a reflection of past risk-adjusted performance, is more time-period dependent. When the market swings dramatically, the star rating is going to be less effective.

Conclusion
Investors should make expense ratios a primary test in fund selection. They are still the most dependable predictor of performance. Start by focusing on funds in the cheapest or two cheapest quintiles, and you'll be on the path to success. (Remember, we highlight funds with expense ratios in the cheapest quintile in the data pages in the back of FundInvestor.)

Stars can be helpful, too, particularly in identifying funds that might be merged out of existence. Even if a 1-star fund starts to perform better, there's always the danger that the fund company will decide that its track record is too poor and will fold the fund, forcing you to move your money elsewhere.

Be sure to go beyond both measures to brush up on a fund's other key fundamentals. Don't look for the 10-second answer. You should understand management, strategy, and stewardship, too, before you send in your check. Our  Fund Analyst Picks take all of these things into account.

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