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Be_Cautious_When_Studying_Mutual_Fund_Ratings

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									Be Cautious When Studying Mutual Fund Ratings

Word Count:
683

Summary:
Wherever you look, you will find various rating systems on mutual funds,
each of which uses a different approach. All of them are designed to weed
through the thousands of funds to get to the best ones. But is there
really such a thing? Does a high rating really mean a fund will do better
in the future? Many people seem to think so. A recent study showed that
Morningstar, North America's most recognized rating system for funds, has
a tremendous influence on fund sales. If Morningstar gives a fiv


Keywords:
mutual funds, investing


Article Body:
Wherever you look, you will find various rating systems on mutual funds,
each of which uses a different approach. All of them are designed to weed
through the thousands of funds to get to the best ones. But is there
really such a thing? Does a high rating really mean a fund will do better
in the future? Many people seem to think so. A recent study showed that
Morningstar, North America's most recognized rating system for funds, has
a tremendous influence on fund sales. If Morningstar gives a five-star
rating, those funds typically enjoy increased sales as a result.

While ranking providers are careful to warn investors that their ratings
don't foretell the future, the star system is, unfortunately, used by
some investors as if they were reading Consumer Reports to purchase a new
drill. Supporters of the ranking approach argue that there's no
subjective component to the star rating. It isn't determined by an
analyst's review, and can't change simply because the service dislikes
the fund's manager or its investment strategy. And that's good.

Performance will vary. Fund performance often falls off and risk levels
rise during the subsequent three years after a fund is given an initial
five-star Morningstar rating, suggests another recent study by Matthew
Morey, a professor at Pace University. One reason for this is that after
receiving a five-star rating the size of the fund grows dramatically,
which then makes the fund unwieldy to manage, he suggests. Since Morey's
study was completed, Morningstar also has changed the way it doles out
top rankings to make them more precise. One of the biggest problems with
all rating systems is that they are not necessarily predictive in nature.
This means they're not really set up to tell you whether certain funds
will necessarily do better in the future. For the most part, the ratings
indicate how much you might have made and how much aggravation you faced
in the process.

Combining risk and return. For example, one five-star fund might post
moderate return scores, but incredibly low risk scores. Another five-star
fund might have much higher-risk scores, but its return score could be
strong enough to help it still rank in the top 10% of the pack.

In some cases, in fact, it's not even the same fund to begin with.
Remember, after a management change, the rating stays with the fund, not
the portfolio manager. Therefore, a fund's rating might be based almost
entirely on the track record of a manager who is no longer with the fund.

Understand how the ratings were developed. Too many people put emphasis
on the results without knowing how the results were achieved. If you are
going to use ratings, take the time to understand how they were developed
and what they really mean. It is not the destination but the journey that
counts.

Past performance is no guarantee of the future. You have probably heard
this disclaimer a thousand times before, but it is really important to
understand. Most rating systems have little to no predictive element in
them. It's natural to think that the best performer of the past will be
the best performer in the future. Unfortunately, it's not that simple.
Just think about it; if it were that easy, investors would just continue
to buy last year's winners knowing that they will be this year's winners.
And that seldom works.

Ratings are a very important element in trying to distinguish between
good and bad funds. Good research, however, goes far beyond just looking
for five stars or an A+. When evaluating funds, look at the quantitative,
measurable characteristics of a fund: returns up against the benchmark,
costs, risks, taxes and manager tenure. Use rating systems as part of
your research, but remember: just because the analysts give them top
marks, it does not mean they will be the best investment in the future,
and doesn’t it mean that they'll be the best investment for you in
particular. Take the time to understand how the ratings were achieved.
This will be the first step to educating yourself about funds.

								
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