I just read a very important study by Vanguard called Mutual Fund Ratings and Future Performance. The title would seems to suggest that this study is going to look at whether mutual fund ratings such as Morningstar’s star ratings are a reasonable prediction of future performance. The study does tackle this issue, but it also addresses an issue that is, I believe, even more important and that most investors are totally unaware of:
empirical evidence has supported the notion that a low-cost index fund is difficult to beat consistently over time. Yet, despite both the theory and the evidence, most mutual fund performance ratings have given index funds an “average” rating.
I have noted this phenomenon in my work, so I was very interested that Vanguard has done such a detailed study. The reason that index funds will tend to get only an average rating is quite simple:
we conclude that investors should expect an average rating for index funds when relative quantitative metrics are used. This is because the natural distribution of the actively managed fund universe around a benchmark dictates that an appropriately constructed and managed index fund should fall somewhere near the center of that distribution.
The study confirms this reasoning using Morningstar’s star ratings over the period from 1992-2009.
So, we are left with the tendency for ratings that just look at trailing performance (such as Morningstar’s star ratings) to assign an average (aka mediocre) rating to index funds, despite all of the evidence to suggest that indexing is likely to out-perform the vast majority of actively managed funds.
Morningstar has noted that expense ratios are the best key predictor of long-term performance, and got a lot of attention for this conclusion, but this does not fully compensate for the inherent bias of ratings such as Morningstar’s star ratings against index funds via the mechanism described by Vanguard.