The Risks of Buying Only 5-Star Funds

Are you looking for the best 5-star funds to buy? Looking at the highest-rated mutual funds can be a good way to begin your search, but don't limit it to just 5-star funds. The star rating isn't always the best predictor of how a fund will do in the future. There are times when 3- and 4-star funds can be smart choices.

Should you invest only in 5-star funds? Before giving the answer to this question in detail, let's learn more about the star rating and how it works.

What Is the Star Rating for Mutual Funds?

The most common place to read and learn more about 5-star funds is through Morningstar, Inc. This firm conducts research on mutual funds, ETFs, and stocks. Morningstar is an investment research firm that rose to prominence in the mutual fund world in large part due to its star rating.

Here's how their star rating works, in their words:

"The Morningstar Rating is a measure of a fund's risk-adjusted return, relative to similar funds. Funds are rated from 1 to 5 stars, with the best performers receiving 5 stars and the worst performers receiving a single star.

Funds are rated for up to three periods—the trailing three, five, and 10 years—and ratings are recalculated each month. Funds with less than three years of performance history are not rated.

The star rating is best used as an initial screen to identify funds worthy of further research, those that have performed well on a risk-adjusted basis relative to their peers. It's a strictly quantitative measure—a high rating doesn't imply the endorsement of a fund by a Morningstar expert."

To be clear, Morningstar rates mutual funds and ETFs based on performance and then adjusts further for risk. For instance, a mutual fund that has done above average in its category for 3-, 5-, and 10-year returns would likely receive a 5-star rating. This may be even more true if the fund got those returns without taking a high level of risk compared to other funds in the same category.

So who wouldn't want to buy 5-star funds that get high returns, relative to their own category, without taking a higher risk than average for the category?

When 5-Star Funds Don't Perform as Expected

Morningstar doesn't promise that future returns will look like they did in the past, nor do they say that the 5-star funds will beat the 1-, 2-, 3-, and 4-star funds in the future. Morningstar does still make its star ratings the main feature of its service.

Below are a few thoughts about the star ratings and how they've fared over the last 20 years:

• Index funds are the best mutual funds for all kinds of investors, from those just starting out to professionals. But index funds rarely receive a 5-star rating because they rarely do better than the averages in the short term. Funds like Vanguard Total Stock Market Index (VTSMX) get a 4-star rating because their returns in the three- and five-year timeframe tend to hover around the median. But the 10-year return often beats the vast majority of category peers. VTSMX gets a 5-star rating in our book, but it won't likely ever get one in Morningstar's book. The VTSMX is closed to new investors. You could instead invest in the lower-cost Vanguard Total Stock Market Index Fund Admiral Shares (VTSAX) or the Vanguard Total Stock Market ETF (VTI). The expense ratio for VTSAX is 0.04%, and the minimum initial investment is $3,000.
• Some mutual funds can have long stretches of out-performance. These can be as long as five years or more because they benefit from more than just an astute management team. Mutual funds, such as sector funds, can have good timing from investing in a handful of stocks that do well for a few years. A fund like this can receive a 5-star rating, but the big performers can also have big losses, and all of a sudden, the 5-star fund turns into a 3-star fund.
• The star rating can be a good starting point for mutual fund research. Keeping your search to just 5 stars is not a good idea, though. In most cases, you'll want to steer clear of buying a 1- or 2-star fund. There are plenty of 3- and 4-star funds that have done well in the long run.

The star rating can be a starting point for mutual fund research. It should only be one of many factors to look at and think about. As long as you are putting diversification and low costs high on your list of needs, you can take the star rating with a grain of salt and still find the best funds for you.