When You Wish Upon a Morningstar

(MoneyWatch)  The previous two posts discussed how difficult it is to pick stocks that will either outperform or underperform the market. This post provides further evidence on just how difficult it is to persistently outperform risk-adjusted benchmarks.

One of the most common investment strategies employed by individual investors is to buy the mutual funds that are highly rated by Morningstar. Morningstar itself provides us with evidence on how successful a strategy that is.

Each June, Morningstar updates investors on how its ratings are doing. It compares the performance of five-star funds to one-star funds. (Not surprising that Morningstar would set an easy hurdle. To find superior performance, all you would have to do is rank funds by expenses and give the lowest cost funds five stars and the highest cost funds one star.)

Let's take a look at some of the results from the latest report. What I found most interesting is that Morningstar touted the results of its class of 2004 -- their five-star domestic funds outperformed their one-star funds by 2.8 percent per year. What they failed to emphasize is that the funds given five stars in 2004 now had a five-year rating of just 3.2. And those same funds now had a ranking of 41, outperforming just 59 percent of all actively managed funds. In other words, the five-star rating was a poor predictor of future ratings.

(We can make that claim because studies show the average actively managed fund underperforms its appropriate benchmark by more than 1.5 percent per year. Thus, outperforming 59 percent of a lousy group is damning with faint praise.)

And the 2004 group was the one Morningstar touted. The 2007 group of five-star funds managed had so far managed to underperform the one-star group! The 2005 group of five-star funds now have a three-year rating of just 3.1 stars. Even worse, the 2006 group had a three-year rating of just 2.9 stars.

The bottom line is that using Morningstar's ratings system is like driving forward while looking through the rear view mirror. The system does a great job of "predicting" the past. And finally, one lesson learned is that while investors buy five-star funds, they actually end up owning three-star funds.

Follow the series:

• Part one: Equity-Like Returns With Bond-Like Risk? Not So Fast!
• Part two: Can You Pick Losing Stocks?
• Part three: When You Wish Upon a Morningstar