I was having a nice back-channel conversation with a substantially frustrated fund manager this week. He read Charles's piece on fund categorization and wrote to express his own dismay with the process. He's running a small fund. It hit its three-year mark and earned five stars. People noticed. Then Morningstar decided to recategorize the fund (into something he thinks he isn't). And it promptly became one star. And, again, people - potential investors - noticed, but not in a good way.
Which got me to thinking about my own favorite one-star fund (RPHYX, which is closed) and Charles's favorite one-shot stat on a fund's risk-adjusted returns (its Sharpe ratio).
And so, here's the question: how many funds have a higher (i.e., better) Sharpe ratio than does RPHYX?
And, as a follow-up, how many have a Sharpe ratio even half as high as RiverPark's?
Hmmmm.
David
Comments
The first answer is: NONE.
RPHIX has the highest three year Sharpe of all US mutual funds three years or older, which is about 6500 funds.
They are all Ultrashort or Short-Term Bond funds...
Alpine Ultra Shrt Tx Optimized Inc Instl (ATOIX), Muni National Short
BMO Ultra Short Tax-Free I (MUISX), Muni National Short
Touchstone Ultra Short Dur F/I Z (TSDOX), Ultrashort Bond
Wells Fargo Advantage Adj Rate Govt I (EKIZX), Ultrashort Bond
USAA Ultra Short-Term Bond (UUSTX), Ultrashort Bond
Wells Fargo Advantage S/T Muni Bd Inv (STSMX), Muni National Short
Homestead Short-Term Bond (HOSBX), Short-Term Bond
They have an average annual return over the past three years of 1.7% vs 4.1% for RPHIX.
OSTIX is another case in point, although for existing shareholders, it's not necessarily a bad thing for the headline star rating to fall to 2* with the reclassification from multi-sector to high yield. Osterweis was accumulating a lot of assets there for a while, & you'd think the change might slow that freight train down a bit.
Regards,
Ted
One Star:
Morningstar Star ratings should never be used as the sole criteria for mutual fund selection.
Investing is not that simple or easy. Even if the Stars are incorporated into a multi-dimensional criteria set, it should never be awarded a top weighting. The empirical research data strongly supports this judgment.
As early as the mid-1990s academic research and the financial industry recognized and identified deficiencies in the Morningstar system. Even Morningstar acknowledged those same shortcomings.
The ratings are singularly dependent on past performance, and persistence is a real investment quagmire. That is the likely incentive that goaded Morningstar to both continuously modify its ratings, and later, to introduce another, independent rating system, its Metals standard.
Here is a reference to a fair Fiduciary News article that nicely summarizes the checkered history of the Morningstar Stars and alternate ways to use them:
http://fiduciarynews.com/2013/01/morningstar-star-ratings-do-they-or-dont-they-predict/
The Stars are really not a pretty picture if deployed as a single determinant. Anyone who used the Stars as their primary fund screening tool must be more than a little annoyed. There are a legion of respectable critics who have savagely attacked the Stars relentlessly. Here is a reference to a Bill Sharpe study that was reported in 1998:
http://www.stanford.edu/~wfsharpe/art/msrar/msrar.htm
Professor Sharpe was not a happy warrior with any simple ranking system, including his own Sharpe Ratio. Here is yet another more recent study conducted by Vanguard:
http://www.vanguard.com/pdf/icrwmf.pdf
The findings are similar although differing in detail because of study objectives. The Star system is a consistent disappointment when applied as a projection tool. The investment world’s pull of the regression-to-the-mean influence overcomes superior past performance as a general rule. Fund costs are a much more powerful correlation factor.
Even Morningstar somewhat accepts this assessment. Here is a dated reference by Morningstar’s Russ Kinnel that explored the issue:
http://www.morningstar.co.uk/uk/news/66497/how-expense-ratios--star-ratings-predict-success.aspx
Kinnel concludes that: “Investors should make expense ratios a primary test in fund selection. They are still the most dependable predictor of performance.” But a multifactor selection model can enhance the success odds.
I’m not advocating that Star ratings are worthless.
I am proposing that when making mutual fund investment decisions, a multifactor model should be assembled that includes costs, turnover rates, management stability, fund size, stock price to earnings ratios, and perhaps a host of other components. These components should NOT be weighted equally. Studies have demonstrated that total fund costs are the dominant success influence, and therefore should be accorded the heaviest weight factor.
By way of disclosure, I do look at the Star ratings when making a fund choice. However, I’m not unduly swayed by its rating. I explore more deeply the reasons why a fund has a lower evaluation. I presently own two mutual funds with two Star scores. I do not find that lowly status to be especially worrisome. It is not the end of the world. Stay the course, guys.
Best Wishes.
Perhaps missing the boat on the impact value of the Sharpe ratio. Too many "other" data pieces jammed into this aging brain mass.
Take care,
Catch
Of course not. Even M* says the star ratings should be only a beginning point of fund research.
Hi AndyJ,
Thank you for reading and replying to my post.
I do believe that most MFO participants are somewhat immune to the attraction of the Star ratings. But not all are, and most of the general pubic blindly fall under its spell. Most investing folks find it hard to resist. As unlikely as it seems, a measurable segment of our population still believes in Astrology.
I had the good fortune to become familiar with Morningstar in its formative years. I enjoyed frequent exchanges with John Rekenthaler during this period. The Morningstar team were true believers that they had invented a winning formula, and they touted it with high confidence. For the uniformed investor, for the novice investor, for the lazy investor , and especially for the investor susceptible to advertisement, the Morningstar star system became the de facto bible.
All behavioral research concludes that folks have a propensity to make decisions with the reactive (system 1) portion of their brain rather than the reflective (system 2) segment. We’re lazy and often default to an easily recalled Star rating when making a mutual fund decision.
The tsunami of Star advertising, mostly funded by the mutual funds themselves, sealed the deal by constantly proclaiming the wonders of their 5-star and 4-star funds. They failed to mention the highly ephemeral nature of these ratings.
The tidal wave of misleading advertisements that extolled the virtues of the Star system motivated the 1990s research that challenged its usefulness as a predictive tool. Yes, Morningstar did admit the limitations of its service, and did modify it. My reference to Russ Kinnel documents that conversion and acknowledgement. But the general investor population still trusts the Star ratings, often to the exclusion of other more dominant factors (like costs).
Please see MFOer BobC’s professional comments on this topic. It dovetails precisely with my amateur’s observations. A lot of investors still slavishly subscribe to the Star ratings. The loyalty persists and can do significant harm to portfolio maintenance like encouraging more frequent fund tradeoffs.
BobC sees it in his daily interactions with clients. I see it through the continuing attention given to it in research projects. That’s why I referenced the 2010 Vanguard study. Professor Bill Sharpe challenged the utility of the Star program in the late 1990s; Vanguard considered it a topic worthy of research dollars in 2010, a decade later. The issue perseveres.
Uninformed, or rookie, or lazy, or advertisement susceptible investors still make investment decisions using primarily, and perhaps singularly, Star ratings. That’s troublesome. It inspired my posting. The Star trap is hard to escape.
I know you haven’t fallen victim to it. I trust that most MFO members avoid it, but some do not. My submittal is merely a cautionary reminder. Take care.
Best Wishes.