Since Morningstar ratings are not predictors of future performance, mutual fund companies should rethink using performance data to market their funds, according to Financial Research Corp., a mutual fund research company in Boston.
Financial Research Corp. drew its conclusions from a study, "Predicting Mutual Fund Performance: A Critical Assessment of Popular Selection Screens," released to customers this month.
The study tracked the one-and three-year performance of 766 mutual funds over a ten-year period by quarter. It found that mutual funds that performed in the top 10 percent over a one year period reverted to the 48th percentile the following year, on average. Meanwhile, the funds that performed in the bottom 10 percent over a one year period reverted to the 52nd percentile the following year, on average. The study also found that those funds that performed in the top 10 percent over a three-year period reverted to the 51st percentile the following year, on average. The funds that performed in the bottom 10 percent over a three-year period reverted to the 50th percentile the following year, on average.
This means that those funds that have the best or worst performance numbers in one- and three-year periods will only become average the following year, on average, according to the study.
"For equity funds, there is no black box method for choosing the perfect fund or a great fund," said Jim Crandall, an analyst at FRC who helped write the study. "The linkage of what happened in the past and what happened in the future is very tenuous."
One of the reasons that great performing funds become average is that massive inflows can have a negative effect on performance by making it harder for a portfolio manager to put the money to work, Crandall said.
The study also found that the smallest equity funds in terms of assets under management were more apt to outperform their category averages. And in many instances, outstanding performance will bring a torrent of money into a fund, weighing it down and making the portfolio manager's job that much tougher and raising transaction costs.
During the past 10 years, the smallest 25 percent of equity funds out-performed category averages 87 percent of the time. During the same period, the largest 25 percent of equity funds out-performed their category averages only 48 percent of the time.
These findings suggest that mutual fund companies should have a "depth and breadth of product line" since great performance is so hard to sustain, said Crandall.
Above all, a fund company should have several growth and growth and income funds- the bread and butter of a large mutual fund complex to help drive the company's sales effort so that if one or more funds plunge in performance, there are others that remain attractive to investors, Crandall said.
Fund executives should weigh how they are going to market their funds either with performance numbers that are bound to change year to year or with "more qualitative" matter, such as the fund's investment process, style purity, or investment model, the study said.
Morningstar research director John Rekenthaler said Morningstar's star rating system is not intended as a predictor of one-year performance.
"They don't tell you what's going to happen in the next year," Rekenthaler said. "It's trying to say what funds made people happy over the long-term."