Long-time readers likely understand this quite well, but newer readers may not yet appreciate how much SMI's approach to choosing mutual funds differs from the investing mainstream. A recent article from Morningstar, Large-Cap Medalist Funds in a Five-Year Funk, illustrates this difference brilliantly.

The article discusses how the stock market has been quite strong over the past five years, but nevertheless, several funds that carry Morningstar's highest ratings (gold or silver) have performed among the worst 25% of their peer groups. The article is an attempt to (1) reconcile this poor performance with the fact that these funds continue to display the positive qualities that earned Morningstar's high rankings in the first place, and (2) explain why Morningstar continues to endorse them as a result.

"Here are five domestic large-cap funds with bottom-quartile five-year returns but Morningstar Analyst Ratings of Gold or Silver, meaning that they have numerous positive features and Morningstar analysts think they are likely to outperform over the long term despite short-term blips" [emphasis added].

Aside from the fact that Morningstar regards five years of under-performance as a "short-term blip," this quote is a great snapshot of the typical industry view of how to approach selecting mutual funds. The conventional wisdom says that if you're not going to buy index funds, you should buy the best "long-term" funds and hold onto them through thick and thin. But because research has shown conclusively that long-term past performance isn't predictive of future performance, the industry is left with the perplexing question of how to identify which funds are the best candidates to purchase.

Morningstar's latest answer is to rate a fund across five areas: people, process, parent, performance, and price. Unfortunately, this rather subjective rating approach gives no indication it will perform any better as a predictive tool than Morningstar's old "star system." When you peel away the veneer, it's clear that the conventional wisdom of how to select funds falls far short of providing an adequate methodology.

Contrast this with SMI's Upgrading approach. In Upgrading, we rank every fund within its peer group, based on a combination of short-term (less than one year) performance intervals. We then buy funds from the top of the category rankings, hold them until they drop out of the top 25% of their peer group, then replace them with a new fund from the top of the category rankings. No subjective insights into the manager's skill, the culture of the firm, etc. Just the facts: how it has performed recently. That's important because studies have confirmed that short-term performance—unlike long-term performance—is predictive of future performance, at least over the coming months. That emphasis on more recent performance ensures Upgrading will never hold a fund through "a five-year funk."

In a nutshell, Upgrading works because the market moves through different phases where it rewards varying approaches. Managers typically don't change their approach, which means any particular fund is going to cycle through good and bad periods of performance. It's not necessarily a reflection of manager skill, it's just a market reality. There really aren't many (if any) "all weather" performers out there. Upgrading gives up the search for these elusive "super funds" and instead seeks to own only those funds in the market's sweet spot right now. As a result, we have to buy and sell funds from time to time, but it's well worth it to stay firmly in the market's cross hairs.

Given that Morningstar's latest ratings system is relatively new, there isn't enough data to say for sure how it will perform. But given the numerous approaches we've seen over the past 20+ years from the likes of Morningstar, Consumer Reports, Forbes, and a host of others, we're not optimistic. When you start from a faulty premise, it's unlikely you'll get the desired outcome.

Thankfully Upgrading provides both a long-term track record showing that it does enhance performance results, as well as a sound rationale as to why it works. Both are important. Throw in the fact that it's straightforward and not particularly time-consuming to follow and it's a strategy most people can easily use as the foundation of their investing plan.