The more commentary I read from Morningstar, the more sensible I think they are. Yet I suspect many advisors are misusing the tools that Morningstar provides, or certainly not using the tools in a nuanced way as Morningstar recommends.
For example, a recent article discussed a very topical issue: how to determine if your slumping fund or advisor has permanently lost their touch. Clients grapple with this issue all the time and, most frequently, get it wrong. Studies show that both retail and institutional investors tend to terminate advisors after a period of poor performance and to hire advisors after a period of good performance. Most often, this period tends to be temporary and the studies have demonstrated that investors cost themselves an enormous amount of money by doing so.
On the other hand, no client wants to be permanently stuck with a lousy manager. So how can you differentiate?
There are a couple of different conditions in which Morningstar suggests you not act too impetuously.
1. Funds that don’t follow the crowd often have very different performance profiles than the broad market. Their ranking can zig when the market zags. (Our Systematic portfolios tend to visit both the top and bottom deciles with regularity.)
2. Sometimes an anomalous time period can make a fund look worse than it is. Relying on the ranking of a value fund at the end of a growth cycle, or vice versa, would probably be a significant mistake.
In both cases, the fund’s peer ranking can suffer, but as Morningstar points out, the ranking often comes roaring back. The rankings are exceptionally fluid because the returns are often tightly clustered. For example:
…most category rankings are based on a tightly constrained range. In the large-value category, a 10-year annualized gain of 1.6% lands a fund in the group’s worst third, but a 3.1% gain puts it in the top third. Neither is good on an absolute basis. It is easy to see how a good month or two is all it would take to vault a fund from the group’s basement to its penthouse, and vice versa.
I’ve added the emphasis because I don’t think the fluidity in ranking is generally understood by the investing public. If a good month or two can swing your 10-year ranking significantly, it seems to me that it is much more important to understand the manager’s process than it is to worry about the temporary ranking. Rankings can be unstable; process is permanent.
Posted by Mike Moody 
