The Rating Game: Not All it's Cracked Up to Be

Utilizing Rating Systems for Fund Analysis

Whether the investor is a 401(k) plan sponsor or an individual investor, once any investor selects the asset classes in which they intend to invest, all investors face the difficult issue of selecting managers within these assets classes. A variety of methods have been used over time, but one method that seems to have captured the focus of many investors is that of the rating system.

Unfortunately, these rating systems tend to be imperfect when it comes to predicting future performance. The basis of most rating systems is some combination of past performance, typically over 3-, 5- or 10- years and a measure of the funds’ risk. The problem with using purely quantitative rating systems is that the information used for each manager is historical.  If you have ever read a mutual fund's prospectus you have encountered the disclaimer that past performance is not an indication of future performance.  The Securities and Exchange Commission makes mutual funds put that disclaimer on a prospectus for a good reason - it is absolutely true.

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