Investing In Five-Star Funds?

It’s not as daft as you’d think.


We asked the good folks at Morningstar if they’d generate a list of all five-star funds from ten years ago, then update their star ratings from five years ago and today. I’d first seen this data several years ago when it had been requested by a Wall Street Journal reporter and shared with us. The common interpretation is “it’s not worth it, since five-star funds aren’t likely to remain five-star funds.”


I’ve always thought that was the wrong concern. Really, I’m less concerned about whether my brilliant manager remains absolutely brilliant than whether he turns wretched. Frankly, if my funds kept bouncing between “reasonable,” “pretty good” and “really good,” I’d be thrilled. That is, if they stay in the three- to five-star range over time, that’s perfectly respectable.


Chip took the data and converted it into a pivot table. (Up until then, I thought “pivot table” was just another name for a “lazy Susan.” Turns out it’s actually a data visualization tool. Who knew?)



Here’s how to read it. There were 354 five-star funds in 2005. Of those, only 16 fell to one-star by 2010. You can see that in the top-center box. Of those 16 one-star funds, none rebounded to five stars by 2015 and only two made it back to four stars. On the upside, 187 of the original 354 remained four- or five-star funds across the whole time period and 245 of 354 never dropped below three stars.


We clearly need to do some refinement of the data to see whether a few categories are highly resilient (for example, single-state muni bond funds might never change their star ratings) and, thus, skewing the results. On whole, though, it seems clear that “first to worst” is a pretty low probability outcome and “first to kinda regrettable” isn’t hugely more likely.