Should we invest based on managed fund star ratings

There is a big industry out there to review all the managed funds available and give them star ratings to try help people choose the right fund that will 'do well' but the problem is, they really have no idea. They are like the fortune telling/horoscope industry, the only difference is there is billions of dollars at play and people base fairly large financial decisions on them.

The data shows that people follow the star ratings - just look at the following graph. It shows cumulative cash flows of 4 and 5 star funds are positive (meaning more people added money to these funds than withdrew month) and negative for 1, 2 and 3 star funds (meaning there is more withdrawals than additions to these funds).

Data provided by Morningstar and adapted by Vanguard

But, how do you the star ratings actually perform? Surely it must be a reasonably decent guide?

The following graph shows the performance (relative to their benchmark) of the different star rating funds for the 36 months following their star rating.

Data provided by Morningstar and adapted by Vanguard

The graph shows that after funds have been awarded their higher star ratings, which is generally based on past performance, they then demonstrate the most under performance. Quite a classic case of a statistical term - mean reversion.

I'll note at this point that on aggregate, all funds collectively under perform the index and that is a fact of life, the index has no costs in it but there will always be costs involved when investing. The collective under performance is usually around the 1% mark which is roughly the average cost of actively managed funds.

So what do we do? Go through and pick the lowest star rating funds? They should under perform the least?

No!

We simply ignore the star ratings and take a passive approach to investing. Don't try pick the top or bottom fund of the year before. Simply have low cost exposure to the asset classes that are appropriate for you. Don't take speculative risks and remain diversified. Over the long term, you will end up with a successful investing experience which results in greater lifestyle outcomes, as that is really what it is all about.

We all want greater lifestyle outcomes and that's what I'll award 5 stars to!