Unreliable Stars and Past Performance
We sometimes get the question from prospects and clients, “Why did you buy this fund if it only has 2- stars?” This question usually comes from someone with a company 401k where star-ratings are prominent or someone who just saw an advertisement promoting the most recent “5-star” fund. While the stars make for good marketing, they do not make for optimal portfolio construction. There are three main reasons we do not rely on these systems:
First, you must understand how the star system works, and the flaws within.
“Star rating” or similar ranking systems have been popularized by Morningstar and Lipper. The ratings are typically calculated at the end of each month and take into consideration the fund’s past performance relative to other funds in its same category. We take issue with these rating systems for several reasons:
They are relative to peers and not benchmarks. If all funds stink, someone still must be top-rated!
They typically measure geometric returns, but not in reference to risk taken (e.g. volatility).
They are short-term oriented (e.g. last 12 months, last 3 years), and results can be based on luck versus skill. To accurately determine manager skill, you need a longer range of time.
Performance numbers in aggregate often benefit from survivorship bias. That is, the bad funds close, making the remaining funds as a category look better.
So, the data itself has problems and the rankings ignore a key component of portfolio design – risk!
Second, you must assume “past performance is predictive of future performance.”
However, research shows that very few funds that are top quartile rated over the past 5 years, retain that top quartile rating over the next 5 years. (Only about 20% according to recent research by Dimensional Funds shown in this short video).
Instead, research shows that low-cost is a better predictor of good future performance (relative to peers) than any rankings.
Finally, star ratings typically emphasize active management, yet traditional active management fails to deliver reliable results versus benchmarks.
The S&P Index vs. Active (SPIVA) studies look at historical investment manager performance versus an appropriate benchmark, and they look at the probability of any persistence by active managers. Every six months they update their study. You can access their studies here.
What do they conclude about active management?
Very, very few active managers beat their benchmark over a 3-, 5-, and 10-year window. And they look at US stocks (large cap, small caps), international stocks, and fixed income.
And, sadly, the few managers that do beat their benchmarks overwhelmingly fail to beat their benchmark in the next time period. There is no indication that persistence exists.
At Kings Path, we are an evidence-based investment firm relying on science and statistics to design and implement portfolios. We emphasize low cost, diversification, and historical evidence. If you would like to learn more about our approach, please reach out.
