It’s easy to see this in a product you understand like a vehicle. But can you spot the equally fluffy and meaningless pitches for financial products?
If the big school had 1,200 students and the small school had only 200, there certainly should be more top scholars coming out of the bigger school. It doesn’t have anything to do with the quality of the teachers. It’s because the big school has six times as many students to start with. (The big school probably has many more failing students, too!)
Back to Fidelity funds. The reason it has so many four-star and five-star funds is because it has so many funds to start with.
I counted 140 unique diversified and sector equity funds in the quarterly mutual fund section of the New York Times, excluding funds with the same portfolio and manager but with different commission structures. That’s far more funds than any other fund company.
Fidelity’s ad was telling the truth. Based on three-year returns, the company has 55 four-star and five-star funds, as rated by Morningstar. If a fund has four or five stars, that means its performance was in the top 32.5 percent among all funds in its asset class. (Five stars means the top 10 percent, four stars the next 22.5 percent.)
Fidelity can legitimately claim 39.3 percent of its funds were in the top two Morningstar tiers, roughly the top third of their peers.
Vanguard, which has index funds we recommend all the time, has 53 unique diversified and sector equity funds. Of these, 34, or 64 percent, have four-star or five-star ratings at Morningstar. One of those funds is rated two stars, and the other 18 are rated three stars.
Out of curiosity, I decided to run a similar analysis of the 23 Dimensional Fund Advisors equity funds. Dimensional is the best mutual fund family I know of, and we use these funds in managing money for clients. I found that 19 of those 23 Dimensional funds, or 82.6 percent of the total, had Morningstar ratings of four or five stars.
Score: Dimensional 82 percent, Vanguard 64 percent, Fidelity 39 percent.
The great majority of Dimensional funds were in the top third of their peer groups, compared with only about two out of five at Fidelity and nearly two-thirds at Vanguard.
Remember the analogy of the failing students at the big high school?
When I looked at Fidelity’s fund lineup, I found 46 funds (or 32.8 percent of its 140) ranked either one or two stars by Morningstar. That means nearly one of every three Fidelity funds ranked in the
bottom third of their peers.
I don’t dispute Fidelity’s claim that it has highly experienced managers. I’d just remind you that those managers were at the helm of the 46 low-rated funds as well. But Fidelity neglected to mention that in its advertisement.
Do star ratings really matter in the first place? Fidelity’s marketing department seems to think so. But I believe that what really matters to investors is results. Savvy investors should use their brains to determine where superior results come from. In my opinion, that is the core of being a successful investor.
Do investment results depend on hiring excellent managers? I don’t think so. Most funds are run by quite talented managers. Do investment results depend on Morningstar star ratings? We shall see shortly.
Personally, I think superior investment results come from being invested in the right asset classes.
In 2005, many investors experienced the stock market as being a go-nowhere place. The Standard & Poor's 500 Index was up 4.9 percent, the Nasdaq advanced 1.4 percent and the Wilshire 5000 gained 4.6 percent.
But investors were likely to do much better than that if they had a proper mix of international stocks as well as those from the U.S., value stocks as well as growth stocks and small-cap stocks as well as large-cap ones.
At the start of 2005, we told investors how to find the best access to each of what we believe are the most important asset classes, whether their accounts are at Fidelity, Vanguard, Schwab or T. Rowe Price. (This advice is always available free online at www.FundAdvice.com.) Investors who took that advice at the start of 2005 had plenty of reason to be glad that they did.
Accompanying this article, Figure 1 shows our fund recommendations at Fidelity, Schwab, T. Rowe Price and Vanguard. For each fund, we show its Morningstar star rating. In Figure 2, you’ll see how much of each portfolio is made up of five-star funds, four-star funds, three-star funds and so on. And you’ll see the 2005 performance for each portfolio.
Click here to see those figures.
These are not portfolios we manage for clients. The table shows what investors can do on their own. I’m guessing that most do-it-yourself investors wish they had achieved returns like these in 2005.
I have not shown the performance for each fund (you can look it up online at Morningstar.com if you’re interested) because focusing on individual funds takes investors’ eyes off the ball. What matters is the portfolio, not the individual pieces that make it up.
Fidelity’s fund lineup in this portfolio is handicapped by the fact that there’s no international value fund and no international small-cap fund of any kind. Still, last year this group of funds, when weighted as indicated, returned 14.4 percent.
(In August 2005, Fidelity began offering the International Small Cap Opportunities Fund (FSCOX), which is now part of our Fidelity suggested portfolio. However, that fund's returns could not be included in our calculations because it was not in operation for the full year.)
Fidelity’s ad focused on star ratings, but as Figure 2 shows, the majority of this very successful portfolio was made of funds rated three stars or less (or in the case of the Small Cap Value fund, no rating because the fund doesn’t have enough history).
The T. Rowe Price portfolio had even better performance with nearly two-thirds of its money in three-star funds. The Vanguard portfolio, the only one with a majority stake in high-ranked funds, was third among this group for 2005 performance, while the Schwab portfolio – the only one with a five-star fund – was in last place.
My conclusion: I find it hard to see any compelling connection between last year’s returns and the number of stars in the funds.
You may wonder why the T. Rowe Price portfolio did so much better last year than the Vanguard one. Most of the difference came on the international side. T. Rowe Price’s International Discovery Fund, which invests in small-cap international stocks, was up 27.9 percent last year. Vanguard, unfortunately, does not have an international small-cap fund that’s open to new investors.
The point is not that T. Rowe Price has better funds or better managers. The point is that T. Rowe Price gave investors access to an asset class they couldn’t get at Vanguard.
Another interesting aspect of these four diversified portfolios helps explain why they did so much better than the U.S. market averages. Each one has 10 percent allocated to emerging markets stocks. A 10-percent slice of a portfolio goes a long way when those funds return 44.3 percent (Fidelity), 36 percent (Schwab), 38.8 percent (T. Rowe Price) or 32.1 percent (Vanguard).
Fidelity’s marketing department would have you believe investors need many funds with high star ratings – because that is what Fidelity offers.
But if you’ll take the time to think critically, it’s easy to realize that Fidelity’s marketing department is not in business to make you a better investor. No, its job is to generate business for Fidelity, thus benefiting the company and its shareholders.
My job is to make you a better investor. If you spend more time using your brains and if you adopt a properly diversified portfolio, I’ve done my job. And if I’ve done my job, I believe you will benefit.
