How should investors use Morningstar mutual fund ratings/grades to select mutual funds? In his July 2014 paper entitled “Morningstar Mutual Fund Measures and Selection Model”, John Haslem surveys the five kinds of Morningstar mutual fund ratings and grades: (1) Morningstar star ratings (one to five stars); (2) analyst ratings (gold, silver, bronze, neutral and negative); (3) total pillar ratings (positive, neutral or negative for fund people, process, parent, performance and price); (4) upside/downside capture ratios; and, (5) stewardship ratings (culture, incentives, fees, board quality and regulatory history). Based on the body of research about the predictive power of Morningstar ratings/grades, he chooses three criteria for screening mutual funds:
- Star rating of 4 or 5 and analyst rating of gold or silver.
- Upside capture ratios greater than downside capture ratios for all three of 3-year, 5-year and 10-year past performance intervals.
- Total stewardship grade of A.
He applies these criteria to the set of Vanguard actively managed diversified (not sector) U.S. equity mutual funds. His selections are current winners, with empirical testing requiring future performance data. Applying the chosen criteria to the specified set of Vanguard funds (about 20 funds), he finds that:
- Only six of the Vanguard mutual funds satisfy the first screening criterion (as of May 14, 2013).
- Only two of these six funds satisfy the second screening criterion (as of June 30, 2013): Dividend Growth (VDIGX) and Equity Income (VEIPX).
- Both these funds satisfy the third screening criterion.
In summary, research-driven application of Morningstar mutual fund ratings/grades applied to Vanguard actively managed diversified U.S. equity mutual funds points to the Dividend Growth and Equity Income funds.
Exchange-traded funds (ETF) similar to the winning mutual funds are Vanguard High Dividend Yield ETF (VYM) and Vanguard Dividend Appreciation ETF (VIG), respectively.
Cautions regarding findings include:
- As noted, out-of-sample performance of the winning funds is to be determined.
- A wider initial universe of funds should yield more winners.
