Where All the Funds Are Above Average

Every week in his one of his most popular series of sketches, Garrison Keillor closes by saying, "That's the news from Lake Wobegon, where all the women are strong, all the men are good-looking, and all the children are above average." At least for now, Keillor's above-average comment applies just as well to how Morningstar's (NAS: MORN) new fund rating system evaluates mutual funds.

With trillions of dollars invested in mutual funds, finding the best fund can be like trying to find a needle in a haystack. To help investors find their way, Morningstar and some of its peers offer fund rating systems to make comparisons easier to make. But as the needs of investors have changed, these systems have had to evolve -- and along the way, they've gotten more complicated.

Going beyond the stars
Morningstar has long been known for its simple star rating system, where every fund that has existed long enough gets between one and five stars. The old star system graded funds on a curve, so exactly 10% of funds received a top five-star rating, 22.5% got four stars, 35% three stars, 22.5% two stars, and 10% one star.

But the problem with the star system is that it focused entirely on past performance. It incorporated both past returns and the risks that fund managers took to produce those returns, but what it couldn't do was to make projections into the future on whether the fund would continue to perform in line with its track record.

That's where the new Morningstar system comes in. It adds the company's proprietary analyst ratings to come up with a more forward-looking approach that investors can use to gauge possible future performance. With ratings of gold, silver, bronze, neutral, and negative, the new system makes fairly clear recommendations. But as a recent article in TheWall Street Journal observed, the system so far has produced a lot more positive reviews than negative ones.

A no-lose scenario?
In particular, among the nearly 350 funds that have received new ratings, 155 earned the top gold rating. An additional 109 received a silver rating, while only eight funds got dinged as negative.

That may remind you of another buy-biased phenomenon: picks among stock analysts. Most Wall Street firms give far more buy recommendations than sell recommendations, a practice that many have criticized as payback for the business that the companies whose stocks they rate give them.

But it's too early to tell whether that bias will persist across Morningstar's fund universe. The company plans eventually to have ratings on 1,500 funds, which could result in a more even distribution of ratings. For now, though, an improbably large number of the funds in Morningstar's system look above average.

How to use the new ratings
Regardless of the new system's shortcomings, one thing is certain: Where the old system and the new one agree, it's a positive sign. For instance, Vanguard Energy earns top ratings on both systems, thanks largely to the long-term results and promising prospects for companies including Chesapeake Energy (NYS: CHK) , Suncor (NYS: SU) , and Ultra Petroleum (NYS: UPL) .

What's a lot harder to tell, however, is how best to evaluate funds that do well in one scheme but not the other. For instance, Clipper Fund has performed terribly, earning just a single star on the basis of big missteps in stocks including Goldman Sachs (NYS: GS) , Hewlett-Packard (NYS: HPQ) , and Bank of New York Mellon (NYS: BK) . But Morningstar gives it its top gold rating, presumably counting on fund managers Chris Davis and Ken Feinberg to ramp up the fund's performance from its lackluster past.

As with any other evaluation method, Morningstar's new fund rating system will take time to assess. Until you can figure out whether the new ratings make sense, view them with caution -- and at most, use them only as one factor among many you use in choosing funds. That way, the selections you end up making won't become funds that time forgot and that the decades cannot improve.

Smart mutual fund choices are just one way you can improve your retirement prospects. Learn a whole lot more from the Fool's newest free special report, "The Shocking Can't-Miss Truth About Your Retirement."

Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitterhere.

At the time thisarticle was published Fool contributor Dan Caplinger still thinks low fees tell more than anything else about a fund's prospects. He owns shares of the ETF equivalent of Vanguard Energy. The Motley Fool owns shares of Ultra Petroleum. Motley Fool newsletter services have recommended buying shares of Chesapeake Energy, Ultra Petroleum, Goldman Sachs, and Morningstar. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy is savvier than Guy Noir, private eye.

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