I haven't gone to Morningstar (MS) in quite some time as I rarely use mutual funds or ETFs, but the other day, I wanted to look up a fund and for whatever reason, I punched in SPY. SPY is the largest ETF tracking the S&P 500 Index. And to my utter astonishment, I saw SPY ranked as 5 stars! I couldn't believe it so I punched in QQQ. 5 Stars!!!
Why is this so remarkable? It means that over 90% of the funds in their respective space are underperforming their benchmark index. From the time I joined our industry until the last time I checked, all index funds were ranked at 4 stars. A MS 5-star fund is in the top 10% of its category. A 4 star falls between in the 67.5% - 90% quintile. A 3-star would fall in the 32.5% - 67.5% quintile, a 2-star would be in the bottom 32.5% and a 1-star fund would be in the bottom 10% worst performing funds. (I don't know why they just don't use five 20's but they came up with this wacky system and pretty much everyone accepts it. I think it was designed to include as many funds as possible as 3-star or above.)
These rankings do not even account for survivorship bias. Over time, more funds have ceased to exist or been merged with other funds than currently exist. MS rankings only consider funds currently in existence. Say over the past 3 years, 10% of funds exited the market. This means over 95% of funds underperformed "average"! (I have no idea how many funds ceased to exist in the past 3 years, I just used 10% because it makes the math exceedingly easy.)
An index fund, if it's doing its job, should perform right at average. In other words, 50% of the capital in that space outperforms and 50% of the capital in that space underperforms the index. So if SPY is a five-star, at least 90% of funds in the large-cap space are underperforming "average"! How can that possibly be?
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