Those ‘A’ and 5-Star Ratings Ain’t What They Used to Be

Major league baseball expanded this month, adding two new franchises. When the season opens next spring, the big leagues will feature a whole bunch of players who weren’t of major-league quality last year.

That “quality inflation” is not so different from what’s been going on in the fund industry.

The ‘90s explosion of new mutual funds has been conferring the title of “mutual fund manager” on a good number of folks who in a less expansionary age might not have made the team.

The concern of investors, of course, lies not in the number of funds, but in determining which ones are likely to be winners. Unlike the way it is in baseball, where a player’s stats are measured against an absolute, a mutual fund manager’s performance is measured against that of other mutual fund managers. The fund-rating services, in other words, are grading on a curve. The far greater number of funds, then, means that a far greater number than before are receiving top ratings.

So if you’re looking for a few good funds, relying on the ratings won’t pare down your choices the way it once would have.

Simply put, ratings work like this:

Lipper Analytical Services gives funds letter grades (sometimes published as number grades) based on percentages: The top 20% within a category get an A (or 1), the next 20% a B (or 2), and so on. Morningstar also uses percentages to create ratings, but the designations are stars, and the percentage cutoffs are different: The top 10% of funds in a category get five stars, the next 22.5% get four stars, the middle third get three stars, the next-lowest 22.5% get two stars, and the bottom 10% get one star.

A decade ago, when there were many fewer funds, just a few dozen would get the top ratings. It wasn’t hard to find out a lot about each of those funds, such as managers’ experience and investing styles. But today, depending on how you do the counting, there are between 7,500 and 13,000 funds. Even the most savvy investors won’t know the story behind any more than a handful of the ones receiving an A or five-star rating.

The rating firms, recognizing the situation, have created more investment categories by which to judge funds’ performances. This makes for better comparisons--high-grade-corporate-bond funds don’t compete with funds focusing on below-investment-grade bonds, for example--but it also can create its own kind of confusion. Lipper, for example, now has about 150 ranking categories--and many funds can legitimately boast of being No. 1.

The paradox is that the explosion of fund choices makes it more tempting for investors to put greater weight on the ratings. In fact, more than 90% of all money flowing into funds goes into offerings that carry Morningstar’s two highest ratings and/or Lipper’s highest. Many advisors won’t sell funds with lesser grades.

But even the fund raters themselves say that investing mainly on the basis of ratings is not such a good idea.

“A ranking is simply a way to put funds in array, to look at them in order, but not to pick funds,” says A. Michael Lipper, president of Lipper Analytical. “The rank is like the cover of a book, and perhaps you shouldn’t buy books based only on the cover. You’ll want to read a review or find someone whose guidance you trust before wasting time and money on the book.”

“Now more than ever, we’re not a conclusion, we’re a jumping-off point,” says Morningstar President Don Phillips. “With so many funds out there, people need independent analysis. It’s a better starting point than working only from a fund company’s marketing materials.”

In addition, he notes, “there is no rating or ranking system that matches funds to an investor. That’s where the individual needs to do their own work.”

Part of that work--beyond determining which categories of funds are right for your portfolio, of course--is establishing the other characteristics you want in a fund beyond a history of good returns. If you want a fund with a portfolio that doesn’t change too many of its stocks often--a lower turnover can reduce volatility and improve tax efficiency--and low expenses and a manager with a tenure of at least five years, make those factors part of your screening process.

Instead of looking at a mountain of five-star funds, then, you will be considering a much smaller list of top-rated funds with, say, experienced managers, expense ratios of less than 1% and an annual turnover rate of less than 50%.

Today’s very populous fund universe makes fund selection akin to buying clothes in a big store. Ratings tell you the size, but you have to take into account your budget, lifestyle and skin tone to determine whether something will work in your wardrobe.

“Remember that what you want is a fund that’s right for you, not always one that tops the rankings,” says Roy Weitz of Fund Alarm, an independent Web site (https://www.fundalarm.com) that evaluates fund performance. “People who chase ratings and always have to be at the top forget that ratings are just one factor. They used to say a lot more about a fund, but with so many funds getting good grades, they don’t tell you much of the story anymore.”