Why NOT to Invest in 5-Star Rated Mutual Funds

Sometimes I have to fly in the face of common practice and point out things that just aren’t right in the investing world. It’s time someone stepped forward and told you the truth about the perfect performing mutual fund portfolios that are placed before you to entice you to buy them. This is one of those times.

One of the dirty little secrets on Wall Street is that Morningstar is a great sales tool to sell you mutual funds, and is NOT a predictor of top performing funds. Looking in the rear-view mirror at past performance, a portfolio of 5-star rated funds can look impressive. The only problem is, no one owned the portfolio you are being shown. It was created the day you came into the office to show the absolute best PAST performance. It was not a portfolio that your Financial Advisor has been offering to anyone and NONE of his/her clients owned that portfolio and got that performance. It is purely a sales tool to show you PERFECT past performance so you buy their suggested mutual fund portfolio. It also has NOTHING to do with future performance, and I suspect, often will have sub-par returns because it may even be the peak of a cycle. It’s all downhill from there.

For example, bond mutual fund performance looks fantastic for the past 10 years, but that’s due to interest rates declining after 9-11, the financial crisis in 2007 and declining interest rates make bond valuations rise. However, since cycles show interest rates are about to move in the other direction for the next 30 years, this could be the absolute worst time to invest in bonds!

Morningstar will show you 5-star ratings of bond funds and could make you think 30 year bonds are the greatest place to invest. But all that really does is get you to invest in those funds. It’s a sales tool. It does nothing to help your performance going forward.

According to a study done by Vanguard, in a three year period, the lowest rated funds actually generated the greatest excess returns, while the highest rated funds generated the least! Did you catch that? 5 star funds performed the worst over the next 3 years and 1, 2, or 3 star rated funds performed the best!

Vanguard’s study also demonstrated that, “an investor had less than a 50–50 shot of picking a fund that would outperform regardless of its rating at the time of the selection.”

Whoa, so ratings aren’t what indicate future performance? It’s a 50-50 shot? Wow. Your advisor won’t tell you that.

In 1966, the economist William Sharpe (the well-resected researcher that the Sharpe Ratio is named after) stated, “all other things being equal, the smaller a fund’s expense ratio, the better results obtained by its stock holders.”

That alone should tell you you’re probably better off buying a Vanguard portfolio than buying Morningstar 5-star rated funds!

Here’s an article by Nerdwallet that did some great research on 5-star rated funds.

But there is another element to consider. While it’s taboo to talk about future performance in the investment industry, now that we know cycles exist and repeat, we can look forward like the billionaires who follow cycles and think differently about how and where to invest.

For example, if cycles tell us that bonds move in a 30 year cycle (which they do), then we should know that the top was in 1981 and the bottom was in 2011. While interest rates have slightly started to move up, we may see the Fed start to raise rates going forward. Not only will rising interest rates cause losses in the bond market (especially 30 year bonds), but it will also wreak havoc with the real estate market (causing home buyers to not be able to afford as large of a monthly payment) and it will cause the national debt to skyrocket.

This is the mindset you must have as an investor. If this, then that. It’s like a chess game. The biggest indicator is what interest rates are doing. That is the 100 pound gorilla in the room.

Understanding cycles is what will help you look FORWARD to determine the best places to invest. That’s how billionaires think before they invest. They think about what investments will do the best going forward? What are the trends and cycles? Where will money grow the fastest?

But I digress. We were talking about why 5-star rated funds are NOT the best place to invest going forward. Sometimes they are the worst, especially if it is the peak of a bubble.

For example, in 2000, there was a technology fund that was up almost 100% in one year. Investors clamored into the 5-star rated fund hoping to get that spectacular past performance in the future. Unfortunately, it was the peak of the internet bubble and over the next few years the fund lost 75%! Investing in funds after they have a big performance year can mean it’s really the peak of a cycle. Think of the shape of a mountain – the cycle goes up one side to the peak of the mountain, only to reverse and go down the other side. That’s how cycles work. Cycles can last different lengths of time for different markets.

Interest rates run in about a 30 year cycle. Real estate in about an 18 year cycle. The stock market in an 8.6 year cycle.

So next time you have a 5-star mutual fund portfolio placed in front of you and the Financial Advisor is showing you what a great portfolio it is – ask this one question – how many of your clients owned this portfolio? Because the computer just spit out the best possible 10 year track record looking backwards, the answer will be zero. None of their clients owned that portfolio and received those returns. Not ONE. EVER. Rather than “hypothetical” returns, we should be asking for real returns their clients received and go from there. Morningstar 5-star past-performance makes any financial advisor look like a hero at the moment you are deciding to invest. It takes regular monitoring of the portfolio to make sure it’s performing well and making adjustments if it’s not.

If you are picking your own funds and using Morningstar, I caution you to not just pick 5-star funds, but to think about what cycle (like interest rates) might have caused that great performance and if it can be replicated going forward. Since interest rates can’t get any lower from here, there’s no chance that long term bonds can repeat the performance of the last 30 years. In fact, they might just be reversing the cycle and coming down the other side of the mountain.

So what can you do?

1. Pay attention to interest rates as an economic indicator. Their direction and movement is important.
2. Don’t just blindly select 5-star funds. Look for funds with low expense ratios.
3. Pay attention to cycles. They repeat and help us see what may be coming ahead.
4. Review your portfolio regularly and make adjustments. Don’t set it and forget it.

I love receiving questions so if you have a question, please email LindaPrivate@LindaPJones.

If you liked hearing about bubbles and cycles, I’ll be talking more about them on my next webinar. Sign up to learn the 5 common mistakes that keep you from attaining financial freedom, click HERE.

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