"Past performance is not necessarily indicative of future performance."
This disclaimer appears many times whenever a mutual fund advertises its past performance. It is 100 percent true.And yet most advertisements for mutual funds include some claim about their "rankings" or "ratings," which are, of course, derived from past performance.
Most investors want to know what the past performance of a mutual fund has been before they ask any other question. Past performance is obviously an objective measurement that should be considered by all investors.
There is a feud going on between Lipper Analytical Services, which provides "rankings," and Morningstar, which provides "ratings," as to which is more valuable in evaluating a fund.
Lipper breaks down the entire fund universe into many small categories and ranks the funds for various time periods. The result is that most fund groups can find some period in which at least one of its funds was ranked No. 1 by Lipper.
This is why so many advertisements claim their fund is ranked No. 1 by Lipper. There are hundreds of No. 1 funds.
Morningstar, the Chicago-based research company, is Lipper's big rival and has become a leader in the industry because Morningstar provides much more detailed information about each fund rather than only past performance.
Morningstar avoids "rankings," never stressing which fund was first in any category. Instead, Morningstar provides "ratings" based on its own analysis.
Separating funds into four broad categories, Morningstar rates funds based on past performance for three-, five- and 10-year time periods, compared with all other funds in that category.
Then it adjusts the ratings for risk based on its own method, using monthly volatility as a measurement of risk.
The result is a rating of one star for the poorest up to five stars for the best. And you can bet the fund with a Morningstar five-star rating will use that in its advertising.
Lipper recently challenged Morningstar ratings with a study that measured the performance of Morningstar's five-star funds during the period from 1990 through 1993. Lipper said more than half of the five-star equity funds underperformed the average equity fund in the subsequent 12 months.
In 1993, Morningstar challenged an advertisement by one fund company that cited Lipper's No. 1 rankings of some of its funds.
The funds were ranked No. 1 by Lipper, but the category selected by Lipper included only about three funds.
It was Morningstar's contention that such rankings were misleading unless the size of the category was shown in the advertisement. The SEC agrees with Morningstar and is requiring more information to be supplied in fund advertisements.
The SEC also is searching for some simple measure of risk that can become an industry standard in advertising.
Neither Lipper nor Morningstar ratings were helpful in the case of Managers Intermediate Mortgage Fund, ranked No. 1 by Lipper in its category and rated five stars by Morningstar during the five years ending in 1993.
Managers Intermediate Fund lost 22.3 percent during the first six months of 1994.
The use of a large percentage of complicated derivatives accelerated its performance during the period of falling interest rates but devastated its results with the rise in interest rates in recent months.
The feud is a ridiculous one. Neither rankings nor ratings are the only way to make a final decision about which mutual fund to select.
Even John Rekenthaler, editor of Morningstar, says, "People who use the stars as magic bullets are making a mistake."
So if you see an ad that claims "Ranked No. 1 by Lipper" or "Rated Five-Star by Morningstar," don't just blindly put all your eggs in either basket. It's just a signpost along the road to a decision.