Stars are doled out on a curve; 10% of funds in any given category get five stars; 35%, three stars; and 10%, just one. Longer time periods are weighed heavier. The rating, of course, can’t tell you if the manager who earned that record has left, or if a promising new manager is turning things around.
The ratings also factor for risk, but lower risk isn’t always better. “You should be taking the appropriate amount of risk,” says Rusty Vanneman, the chief investment officer of Omaha, Neb.–based CLS Investments. “In a bear market, for example, the funds that pop up as five star will tend be lower-risk. If you rotate to those five-star funds, you may not have enough risk to participate in the recovery.”
Star ratings are a reflection of past results, which aren’t predictive of future returns. Of the 827 funds that had five-star ratings 10 years ago, just 45% still have a five- or four-star rating today. Of 469 funds with one-star ratings a decade ago, nearly half are rated one or two stars today, while 14 have five stars.