If you are like many investors who invest in mutual funds you may put too much emphasis on Morningstar®’s star rating for funds. But is having a portfolio of all five-star funds really the most important thing in constructing a portfolio? Is it the magic potion for a successful portfolio? Do you even need a financial planner to recommend investments for you?

First of all, it’s pretty easy to pick a five-star fund. Just go to Morningstar’s website, click on “Tools”, then “mutual fund” under the “Basic Screener” heading, click the five-star box in the “Ratings and Risk” section and then select whatever other search criteria is of interest to you and voila!, you have yourself a list of five star funds.

Is that all you need to do to be a successful investor? We think not. Surely, it’s better to pick good funds than bad funds, but picking funds is only part of creating a solid portfolio.
You need a portfolio that is broadly diversified across a number of distinct asset classes that are not highly correlated with each other (i.e., their returns don’t move in lock step with each other. - one will be up when another is down, and so on). Picking several five-star funds that are all of the same type doesn’t do much for your portfolio.

Morningstar typically says that the mutual fund rating should just be the start of your search for a good fund. We look at ten to fifteen different factors, depending on the asset class, when we research our recommended funds. In two previous blogs, we outlined a number of factors investors should consider when searching for good solid funds in which to invest (Tips on Picking a Mutual Fund, Parts I and II, February 22 and February 25, respectively).

Can you expect five-star funds to do better than a three-star or four–star fund? In a June 1st, 2010 article in the Wall Street Journal titled “Investors Have Stars in Their Eyes”, by Sam Mamudi, Mr. Mamudi writes: “ The trouble is that investors seem to forget that star ratings are backward-looking, based on a fund’s past performance, and studies have shown the ratings have no predictive value.” It’s not unusual for a fund rated five stars this year, to be rated just one or two stars next year and vice versa.

The article discusses a study that showed during a ten-year period, starting December 31st, 1999, of the 248 funds with a five-star rating at the start of the period, only four retained their five star rating at the end of the period. Morningstar points out that they changed their methodology in 2002 to 48 categories instead of just the four categories they previously used.

Regardless of the criticism of the star ratings, we believe considering funds’ star ratings are a good place to start. In the article, Morningstar points out that higher rated funds typically have lower expenses and lower turnover, factors that bode well for fund performance. Whatever you do, don’t just focus on fund ratings. There are some great three-star and four-star funds out there that have served investors very well over the years.