David John MarottaDavid John Marotta is the President of Marotta Wealth Management, a fee-only financial planning and asset management firm in Charlottesville, Virginia. He is an oft-quoted writer and speaker on financial matters and his weekly financial column can be found at www.eMarotta.com
Host: Can I just look at the number of stars a fund has in Morningstar?
David Morotta: Morningstar is a great company and we use their research a lot. They have what is called a mutual fund star ranking system. A Five Star funds are the best and one star funds are the worst and a lot of people simply use Morningstar s number of stars to decide which mutual funds are the best and which ones are not.
Morningstar is always increasing their research and trying to do a better job. Back in 2000, 2001, 2002, they lumped all US stocks together, this was the time at which the markets were turning from a growth portfolio that did well in the 1990s to a value portfolio that did well after 2000.
In Morningstar all of the aggressive growth, large cap mutual funds had five stars and all of the value and all of the value in small cap had one star. At the very moment at which the five star funds were going to do awful and the one star funds were going to do the best because the categories were changing. Now, since then Morningstar has increased the number of categories tremendously.
So, that they have a category for large cap growth and they have a category for small cap value. So, that means that means that large cap growth funds and small cap value funds are each evaluated in their own categories and a five star fund is the best large cap growth fund with returns.
However their categories are still not big enough. So, they may have a category called natural resources. Natural resources gets diversified between oil and natural gas and precious metals and gold. Now, that Morningstar has more categories their rating system is better but even within a category they may not distinguish between two very different investments.
They have a category called natural resources that includes oil and natural gas, but it also includes precious metals and mining companies and one may do very different than the other. So, it is possible to pick the best fund in a category that Morningstar does not define properly and you are picking a one star fund simply because it is lumped in with other things that do not move in sink with it.