The Skinny on Fund Scores Funds use all kinds of rankings and ratings to prove that they're the tops. Here's what those numbers really mean
(MONEY Magazine) – In the Tennessee Williams play Sweet Bird of Youth, an aging actress wakes from a drunken stupor to realize she's spent the night with a gigolo. Still clutching a sleep mask to her eyes, she asks him if he's attractive. "I used to be the best-looking boy in this town," he says. The actress pauses, then asks, "How large is the town?"
Give her this much: She has a solid grasp of statistics. Whenever someone claims to be the best, the question to ask next is, "The best of what?" This is especially critical for fund investors. We've all seen ads that boast of "top rated" funds or read about managers who beat 90% of their category. But what do these numbers really mean?
There are two ways that fund returns usually get sliced and diced. RANKINGS Two firms, Lipper and Morningstar, produce most of the fund comparisons you see. Both sort stock funds into 30 to 40 categories, with diversified funds grouped by investment style--that is, by the size and the valuation of their stocks. So when Hotchkis & Wiley Large Cap Value is ranked No. 1 in total return over three years by Morningstar, it's being measured against other funds that buy cheap blue chips.
Makes sense, but there are a couple of wrinkles. First, funds change styles, and that means they'll switch categories. (Russ Kinnel, Morningstar's director of fund research, says this happens to about 5% of U.S. stock funds every six months.) It may not make sense to compare their long-term records with their new peers. Second, when was the last time you thought you needed a "midcap blend" fund? These fine distinctions mean a lot to investing pros. But if you just want to put most of your IRA into a decent stock fund, a better measure is how a fund fares against the no-brainer alternative--a low-cost index fund like Vanguard Total Stock Market.
STARS Getting a four- or five-star rating from Morningstar is marketing gold for fund companies. So what's behind this rating? Morningstar takes the same relative return data we've just discussed and adds a twist, factoring in sales charges and the volatility investors experience. That's why a high-risk fund that earned 70% last year may rate just one or two stars. Funds are rated only against others in the same category, which helps you compare apples with apples. What stars can't tell you is whether you should invest in that category at all. Most investors would be better off putting the bulk of their money in a three-star large-value fund than in, say, a risky tech-sector fund with five stars. What counts isn't who you beat but how much money you get to take home. --MAGGIE TOPKIS