A random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing

THE MORNINGSTAR MUTUAL-
FUND INFORMATION SERVICE
If recent performance is not a reliable indicator in choosing a
mutual fund, what is? I have often said that the two best
things that have happened to the mutual-fund industry are
the arrival of Jack Bogle, who started the low-cost, consumer-
friendly Vanguard Group of mutual funds during the mid-
1970s, and Don Phillips, who in the early 1990s initiated the
extremely useful Morningstar Service, which publishes
information on mutual funds.

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Basically, Morningstar is one of the most comprehensive
sources of mutual-fund information an investor can find. For
each mutual fund, it publishes a report crammed full of
relevant data. Its reports show past returns, risk ratings,
portfolio composition, and the fund’s investment style (for
example, the fund invests in established large companies or
smaller growth companies; favors “value” stocks with low
P/E ratios; buys foreign or domestic stocks or both; and so
on). The reports indicate whether the fund has any sales
charges (load fees) and shows the annual expense ratios for
the fund and the percentage of the fund’s asset value
represented by unrealized appreciation. If you buy actively
managed funds you should look for no-load, low-turnover,
low-expense funds with little unrealized appreciation to
minimize future tax liability. For bond funds, Morningstar
gives data on returns, effective maturity, quality of bonds
held, and information on loads and expenses.
The Morningstar Service also uses a five-star rating
system. It rates past performance, taking into account broad-
market returns and the costs and risks associated with getting
those returns. The top funds are given five stars—two more
than Michelin assigns to the top restaurants in the world. The

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stars are useful in categorizing past performance. Unlike the
Michelin stars, which virtually guarantee the diner a meal of
the designated quality, however, the Morningstar ratings do
not guarantee an investor continued superior performance. In
the past, five-star funds have not done better than three-star
or even one-star funds. The wise investor will look beyond
the stars in making appropriate investment decisions.
Is there any way to select an actively managed fund that is
likely to be an above-average performer? I have performed
many studies of mutual-fund returns over the years in an
attempt to explain why some funds perform better than
others. As indicated earlier, past performance is not helpful in
predicting future returns. The two variables that do the best
job in predicting future performance are expense ratios and
turnover. High expenses and high turnover depress returns—
especially after-tax returns if the funds are held in taxable
accounts. The best-performing actively managed funds have
moderate expense ratios and low turnover. The lower the
expenses charged by the purveyor of the investment service,
the more there will be for the investor. As Jack Bogle, the
founder of the Vanguard Group, puts it, in the mutual fund
business, “you get what you don’t pay for.” I suggest that

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investors buy only actively managed funds with expense
ratios below 50 basis points (½ of 1 percent) and with
turnover of less than 50 percent. Expense ratios and turnover
statistics are available on the funds’ Web sites and from
investment sources such as Morningstar.