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Rekenthaler Finds Correlation Between Past Ratings and Future Performance for Top Funds

Morningstar’s John Rekenthaler took issue with a Wall Street Journal article that discussed the decline of funds formerly rated five stars by Morningstar, finding that, “[y]ou'll see many once-proud, five-star funds have dropped to four stars, three stars or worse.” The Journal noted that of the funds that had a five-star rating in July 2004, the July 2014 ratings had dropped one star for 37%, two stars for 31%, three stars for 14%, and four stars for 3%. Using both the Morningstar data as well as data from an S&P Dow Jones Indices study, “experts and fund managers” offered the following suggestions for investors interested in active funds: avoid the draw of a famous manager, aim for consistency over volatility, be careful of quickly growing funds, choose simplicity over complexity, consider tried and true funds, select balanced funds, and look to future potential.

Rekenthaler objected to the idea that the data cited in the article provides evidence that past performance does not offer a prediction of future performance. Instead, he argues that a more proper measure would be to review the distribution of new ratings for top funds against the distribution for all funds. Using this measure, he found that subsequent ratings for top funds skewed higher than for the general fund population, evidence that he suggested proved a correlation between past results and future results. Rekenthaler further argued that the article “turned the funds' victory into defeat” because “[e]valuating the future performance of a pool of current winners means measuring decline” even though the performance remained fairly strong.  In addition, Rekenthaler pointed out that the article ignored a decline in five star rated index funds – a symptom of the “common, casual, and subconscious discounting of the achievements of active management.”