Morningstar & NoLoad FundX: Two Different Approaches

November 11, 2011

At first glance, it may seem like Morningstar has a similar mutual fund rating system as NoLoad FundX. We both award stars to mutual funds based on past performance and we both take risk into consideration, but our approach and Morningstar’s are really quite different.

Risk vs Style

Morningstar groups funds by style, separating large cap from small cap, international from domestic, and growth from value in order to compare funds with others in their same category. We group equity funds by risk in Classes 1 through 4, not by style. This way we can compare different kinds of funds within particular risk parameters and know when certain styles are in the lead. When value funds outpace growth funds (a trend that can last for several years at a time), Upgrading will steer us into value funds. Morningstar considers risk by adjusting down the ratings for higher risk funds in a category and bumping them up for lower risk ones.

Near Term vs Long Term

We select funds based on near-term performance, while Morningstar looks at long term performance. Morningstar’s star-rating is based on a fund’s risk-adjusted performance over the trailing 3, 5, and 10 year periods. We look at how a fund has performed over the trailing 1, 3, 6 and 12 months. After all, we aren’t planning to hold funds indefinitely – we hold a fund only as long as it outperforms its peers and then we move on. Despite these key differences, there are times when our ranks align with Morningstar’s ratings and other times there are glaring differences.

A System vs A Suggestion

Morningstar provides a valuable service to investors – its data and analysis are widely admired in the industry. They employ an army of researchers to collect information on thousands of mutual funds. But the star system itself is not very predictive of which specific funds will outperform in coming months or even years, a fact Morningstar acknowledges. Five-star funds apparently do outperform funds with fewer stars in aggregate. But exactly which of those hundreds of 5-star funds should you buy? That’s not so clear. When a fund falls from a 5-star rating to a 4-star in Morningstar, what action should an investor take? Sell the fund and move to a 5-star alternative? That’s also not very clear.

Morningstar carefully states that their rating is “intended for use as the first step in the fund evaluation process. A high rating alone is not sufficient basis for investment decisions.” This is perhaps the biggest difference between our rating system and Morningstar’s: NoLoad FundX gives specific directions on what actions to take each month. When a fund drops below the top 30% of its class, it is explicitly labeled a sell in our system. Which funds to buy in their place is also clear – buy the highest-ranked funds you don’t already own.

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