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  • Writer's pictureEric Hahn

Why You Shouldn't Buy a Highly-Rated Mutual Fund

Say a mutual fund makes a "best buy" list or is highly rated. Should you buy it?

The latest round of research, which confirms decades of academic findings, suggests you should avoid top-rated funds. They rarely repeat their best years.

According to a new study by Baird Wealth ManagementResearch, not only do mutual fund ratings not predict future performance, they may be reliable red lights that should warn you against buying a fund.

Baird analyst Aaron Reynolds asked the question "do fund ratings predict future performance?" Here's what he found:

* For US stock funds, the research found that ratings were negatively predictive of future performance,

e.g. a high rated fund will perform worse than a low rated fund.

* For international stock funds, there did not appear to be a similar trend.

* For bond funds, ratings and performance showed a positive relationship and higher rated funds tended to show higher performance.

How do you explain these results? Often, when a stock fund manager has a good year, it's due to chance. Many funds reflect the market as a whole, that is, they are "closet" index funds that mimic the market at 10 times the cost.

If stocks in general have a good year, then most stock funds will do the same. But having a good year should not be confused with persistence of performance. They probably won't repeat their results.

For bond fund managers, there's a greater likelihood of repeating a decent year because bonds have been in a bull market for about 30 years, with the exception of last year and and few blips in between.

It would've been incredibly difficult to lose money in bonds in 2008 and in any year in which interest rates have been flat or falling. It's just inertia. Of course, that environment is changing. Bond prices may fall in the coming years as the Federal Reserve ratchets up interest rates -- if the economy continues to grow.

How to Invest

I stopped compiling mutual fund lists based on past performance more than a decade and a half ago when I first saw the studies on how ratings utterly failed to predict future results. They just don't make sense and rely upon our innate, short-term bias to expect that recent trends will continue into the future.

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