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Should You Worry if Your Fund Never Receives a Top Rating from Morningstar?

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June 2006
Should You Worry if Your Fund Never Receives a Top Rating from Morningstar?

Some investors may start to doubt their mutual fund choices if their fund doesn't receive a top rating from Morningstar. Should they?

As you may know, Morningstar rates funds based on performance over the last three, five, and 10 years on a scale ranging from one-star (lowest) to five-star (highest). Ratings are assigned on a curve, with 10% of funds receiving five stars, 22.5% receiving four stars, 35% receiving three stars, 22.5% receiving two stars, and 10% receiving one star.

This information can be an important part of the fund analysis process. However, some investors tend to use the Morning star ratings as the sole criteria for gauging a fund's performance. That approach might not be prudent for a number of reasons.

First, not every fund has an equal chance of receiving the highest rating. Risk-adjusted returns (RAR)—on which Morningstar bases its ratings—are calculated over one of four broad categories. These include domestic equity funds, international equity funds, taxable bond funds, and municipal bond funds. But in each RAR category, there are different asset classes, such as small-cap funds and large-cap funds, and at any given time one of those asset classes may be performing better than the others. As a result, funds in asset classes that are performing well at a given time may receive a higher rating than others.

Second, ratings tend to favor newer funds in some cases. When Morningstar calculates overall ratings, ten-year statistics account for 50% of the overall score, five-year statistics account for 30%, and three-year statistics account for 20%. But if only five years of data is available, the five-year period is weighted 60%, and the three-year period 40%. And if only three years of data is available, the three-year statistics alone are used in the overall rating. As a result, older funds that did not perform well in their early years but perform well now could receive fewer stars than their current performance justifies.

Finally, it may go without saying, but past performance does not guarantee future success. This year's winner could be next year's loser—and vice versa.

The moral of the story: although Morningstar ratings can be a very helpful tool for evaluating a fund's performance, no third-party system should take the place of the work that you and your financial advisor do to analyze your specific investment objectives.

Plan Your IRA Distributions

Like many seniors, you have probably avoided removing money from your

IRA for as long as possible. The tax-deferred earning and growth can make

many investments in an IRA look much better than their taxable counterparts. But

there will come a time (at age 70�) when the IRS requires that you start

withdrawing funds and paying income tax. With some planning, however, you

can make the Required Minimum Distributions (RMD) as painless as possible.

Start early

The sooner you start planning how you will take money from your IRA, the

better. Three to five years is ideal. This will give you a good projection of your

income from pensions, Social Security, and investments. Then you will be able to

decide whether the tax bite would be less if you start taking distributions now or

later.

Don't double-up

You are not required to make the first withdrawal until April 1 of the year after

you turn 70�. But if you wait until then, you will have to take a second distribution

by December 31 of the same year. Two distributions mean more income tax and

might bump you into a higher tax bracket.

Beware of Social Security creep

Fifty percent of your Social Security income is taxable when your adjusted

gross income (AGI) hits $32,000 ($25,000 for single taxpayers). It rises to 85%

when your AGI reaches $44,000 ($34,000 for singles). Planning your IRA

distributions may show that you might possibly be able to have better control on

the amount of tax you pay on your government benefits.

Convert to a Roth IRA

Prior to age 70�, you can transfer some or all of your assets from your IRA to

a Roth. The move will be taxable, but you will not be faced with the RMD rule.

This could be especially beneficial if you have investments that have dropped

significantly in value, yet you believe they will recover. In addition, withdrawals

from a Roth IRA are not included in calculating the tax rate on your Social

Security benefits.


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