When choosing mutual funds for a portfolio, investors look for funds that have strong performances and good returns. Though returns can never be guaranteed in an ever-changing market, there are some common ways that investors can judge the quality of fund, one of the more popular being Morningstar’s star rating system. Though these ratings are generally accepted as fact, they can sometimes be deceiving.

How Fund Performance is Measured

To determine how a mutual fund performs, an analyst will calculate its total return. According to Investopedia, total return “is the sum of the change in a fund’s net asset value, its dividends, and its capital gains distributions over a given period of time.” Analysts will look at a fund within a given period of time, generally five or ten years, to analyze an investment’s performance. When the total return is calculated, it is expressed as the net of a fund’s expenses.

Analysts generally consider the environment of the market to evaluate the fund’s performance potential. This is why a 10-year measurement of performance is generally the most accurate, as it reflects many different market conditions. Analysts also benchmark funds in order to track total return performance. There are many indexes against which the performance of an investment can be measured.

How a Fund Receives Their Rating

Investors have generally looked to one of two companies to provide mutual fund ratings. Morningstar’s evaluation metric is a five-star scale, whereas Lipper uses five categories to rate funds across five different measures. Morningstar organizes mutual funds based on the type of investment in the fund portfolio, with 10% receiving a 5-star rating. Lipper rates mutual funds based on consistency of returns, preservation of capital, expense ratios, total return, and tax efficiency. Mutual funds are rated in all five categories, with a rating from one to five.

A Fund’s Performance, 10 Years Later

Though Morningstar is a big name in the financial industry, and they have a lot to offer in different arenas, their star-rating system is not the only, or even the most accurate, way to analyze what funds are the best investments. In a study by the Wall Street Journal, funds that were once top-rated by Morningstar (5-star funds) were analyzed ten years later. Analysts found that the majority of the biggest five-star funds from 5-10 years ago no longer have a top rating.

According to the study, 10 years after the analyzed funds had received their five-star rating (July 2004), 37% had lost one star, 31% had lost two stars, 14% lost three, and 3% lost four. As reported, “two of the top-rated funds from 10 years ago. . . went from having five stars in July 2004 to having just one star and two in July of 2014.” Only 14% of five star funds had the same rating 10 years later, said Morningstar. Other studies also suggest that it is difficult for leading funds to stay on top. S&P Dow Jones Indices found that only 2 out of 715 top-performing mutual funds stayed in the top 25% for a four-year period.

Lessons to be Learned

Morningstar’s star-rating system is not the most accurate predictor of future behavior. Their ratings are based on past performance and have very little bearing on what a fund will continue to do in the future. In addition, their star ratings can change for a multitude of reasons, not just that the fund decreased in value. Stars can also be changed due to new categories being developed within the Morningstar system, thus leading to confusion in the historic and present value of a fund.

No matter what the stars say, there are a few key points to remember. First, volatility should be considered. The Morningstar data showed that the funds producing consistent returns were the ones with low volatility and less risk. Second, balanced portfolios, or those with a healthy mix of stocks and bonds, were more likely to retain steady ratings over time.

Researching funds is highly recommended. However, only picking funds based on their high star ratings can lead to disappointment. Sticking with the fundamentals, and employing a registered financial adviser, can help investors put together a strong portfolio that will weather the ups and downs of the market in the long run.