Chasing Top-Rated Funds: Why Are We Investing In Outliers?

This is the second installment in a multi-part research series on fund ratings. In this series, we will use proprietary functionality leveraged by our clients to develop custom fund rating systems.¹

In the first installment of this series, we discussed the volatility of 10-year fund ratings as the last of the Global Financial Crisis (GFC) faded from the historical window. Now, we’d like to address in more detail one of the reasons this happened.

The reason, in a nutshell, is that fund ratings―based on any statistic―identify outliers. Naturally, you might say, that’s the idea. And it is―to an extent. But the why matters. Are the top funds consistent superior managers? Did they make a shrewd tactical allocation move at the right time? Or are they rewarded for something that has nothing to do with skill?

Let’s return to our illustration using the 10-year MRAR statistic calculated in MPI Stylus.²³ We compute 10-year MRAR ranks and 10-year Beta vs. the S&P 500 Index within the Large Blend Morningstar category of about 700 funds that are currently active with inception January 2008 or earlier. We first compute over the 10-year window (January 2008 through December 2017), where most of the GFC is included, as seen in the below chart.