It’s not the stars, it’s the advice.
When meeting with new clients and presenting our investment recommendations, we sometimes get the question why the funds we recommend are not all rated five stars by Morningstar. And yes, we freely admit that some of the funds we use only have four or three stars, but that simply doesn’t matter.
You see, your long-term investment success is not based on how many stars your funds have, but rather it is based on your investment plan, diversification and risk control and, maybe most importantly, your behavior.
For instance, a fund we use in client portfolios, DFA Micro Cap, which is a small cap blend fund, receives a three-star rating from Morningstar. According to Morningstar data through July 31, 2007, DFA Micro Cap has a five-year annualized return of 17.98%.
On the other hand, Morningstar gives Keeley Small Cap Value a five-star rating. This fund, which is also a small blend fund, has a five-year annualized return of 21.60%. Naturally it seems that anyone would get better performance using the Keeley fund over the DFA fund.
Of course, these figures don’t tell the whole story. Morningstar is making a new calculation called “investor return.” Morningstar follows cash flows into and out of funds, which represents investors buying and selling. Using this data, they are able to calculate what the average investor’s return is in a fund.
For instance, the average investor’s return in DFA Micro Cap was 17.16% over the five year period, which is slightly less than the fund’s return of 17.98%. However, the average investor’s return in Keeley Small Cap Value was 15.18%. In other words, the average investor’s return in Keeley Small Cap Value was 6.42% less than the fund itself over the last five years (and less than investors in the DFA fund).
What about funds offered through “Financial Advisors?” Nationwide Small Cap A receives five stars from Morningstar and has an impressive five year annualized return of 23.50%. However, the average investor’s return over those same five years was only 10.71%. How did investors in this fund, who should have been receiving professional advice, annualize 12.79% less than the fund itself over the last five years?
So what does this data tell us? It tells us that the average investor tends to buy and sell at the wrong time, usually buying after a fund has experienced excellent returns and selling when a fund declines.
The next time you analyze an investment or have an advisor propose investing in a five-star rated fund, keep in mind that the returns you see are not always the returns you get!
You see, your long-term investment success is not based on how many stars your funds have, but rather it is based on your investment plan, diversification and risk control and, maybe most importantly, your behavior.
For instance, a fund we use in client portfolios, DFA Micro Cap, which is a small cap blend fund, receives a three-star rating from Morningstar. According to Morningstar data through July 31, 2007, DFA Micro Cap has a five-year annualized return of 17.98%.
On the other hand, Morningstar gives Keeley Small Cap Value a five-star rating. This fund, which is also a small blend fund, has a five-year annualized return of 21.60%. Naturally it seems that anyone would get better performance using the Keeley fund over the DFA fund.
Of course, these figures don’t tell the whole story. Morningstar is making a new calculation called “investor return.” Morningstar follows cash flows into and out of funds, which represents investors buying and selling. Using this data, they are able to calculate what the average investor’s return is in a fund.
For instance, the average investor’s return in DFA Micro Cap was 17.16% over the five year period, which is slightly less than the fund’s return of 17.98%. However, the average investor’s return in Keeley Small Cap Value was 15.18%. In other words, the average investor’s return in Keeley Small Cap Value was 6.42% less than the fund itself over the last five years (and less than investors in the DFA fund).
What about funds offered through “Financial Advisors?” Nationwide Small Cap A receives five stars from Morningstar and has an impressive five year annualized return of 23.50%. However, the average investor’s return over those same five years was only 10.71%. How did investors in this fund, who should have been receiving professional advice, annualize 12.79% less than the fund itself over the last five years?
So what does this data tell us? It tells us that the average investor tends to buy and sell at the wrong time, usually buying after a fund has experienced excellent returns and selling when a fund declines.
The next time you analyze an investment or have an advisor propose investing in a five-star rated fund, keep in mind that the returns you see are not always the returns you get!
posted by Triton Wealth Management at
9:33 AM
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