5, 4, 3, 2, 1.
Take a list of the top-rated mutual funds from years ago—those with five-star ratings from Morningstar Inc. —and look at them now. The sobering fact: You'll see many once-proud, five-star funds have dropped to four stars, three stars or worse. And there are lessons to be learned from that.
Morningstar, at the request of The Wall Street Journal, produced such a list of the top-rated stock and bond funds and what has become of them. Analysts at the investment-research company found the vast majority of the biggest five-star funds from five and 10 years ago no longer have a top rating.
For investors, it isn't necessarily terrible if their fund drops a notch; of funds that had a five-star overall rating as of July 2004, 37% had lost one star 10 years later. But 31% lost two stars, 14% dropped three, and 3% lost four. Two of the top-rated funds from 10 years ago, Columbia Marsico International Opportunities Fund and Fairholme Fund, went from having five stars for July 2004 to having just one star and two, respectively, for July 2014. Only 58, or 14%, of the 403 funds that had five stars in July 2004 carried the same rating through July 2014, Morningstar says.
One encouraging finding: While the 10 largest five-star funds (see chart) may not all have kept their five stars after 10 years—only one did as of July—all outperformed their peers.
Still, a separate study suggests it is even more difficult for a leading fund to stay at the top: S&P Dow Jones Indices analyzed 715 top-performing mutual funds, focusing on U.S.-stock funds for the past four years through March, and found that only two stayed in the top 25% through a four-year period.
A lot of advisers, of course, think everyone should put their money in low-cost index funds because managers can't beat the market over the long term. For those who are looking for more-active managers, though, the Morningstar data offer lots of lessons.
We asked experts and fund managers to look at the data, and tell us what lessons investors can glean.
Sometimes investors are drawn by funds that have a strong presence at the helm. The allure is irresistible: to invest in a fund in which one person calls the shots, especially if the fund is doing particularly well.
David Snowball, publisher of the Mutual Fund Observer website, highlights the Marsico and Fairholme funds as examples of funds that were top performers under charismatic managers— Tom Marsico and Bruce Berkowitz, respectively—and have faltered. "[Marsico] was a family very much focused on Tom Marsico and his bold take on investing," Mr. Snowball says. The same is true of Fairholme, he says, "which has been struggling in a number of ways lately."
Mr. Berkowitz couldn't be reached for comment. A spokesperson at Marsico said: "The investment team is 100% focused on finding unique investment ideas and generating above average investment performance for our clients. One example of our team's progress towards that goal is the Columbia Marsico Global Fund's top 3% ranking in its category over five years."
Think again. Many of the top-rated mutual funds in the Morningstar data that have been producing consistent returns actually have low volatility and reduced exposure to risk.
Six of the 10 largest funds with five stars 10 years ago had a 10-year standard deviation less than their category average through July 2014, and three had deviations that were close to their category average, according to the data produced by Morningstar.
As many as 19% of the 58 funds that retained a five-star rating over a 10-year period, including through the financial crisis, were in the conservative- and moderate-risk-allocation categories. One such fund is Vanguard Wellesley Income, a conservative-allocation fund that also grew throughout that time to more than $38 billion in assets from nearly $10 billion.
"Every conservative-allocation fund [in the Morningstar data] remains a good investment today," says Mr. Snowball. Sometimes being boring pays.
Some mutual funds aren't good at adapting their strategy to their growth, says Russel Kinnel, director of fund research at Morningstar.
As investors move their cash to successful funds, the managers have to figure out how to invest the money. Some can feel they need to invest it quickly, which could cause the manager to make the wrong investment.
Mr. Kinnel highlights Thornburg International Value, a fund that has gone from managing assets of $2.1 billion at the end of 2004 to more than $18 billion at the end of 2007—and has seen its five-star rating drop to a two.
"They've had tremendous success, but they've gotten too big and that has impacted the performance," says Mr. Kinnel.
Bill Fries, the fund's co-manager, says getting bigger hasn't caused the trouble.
"I would concede, it is easier to manage a small portfolio than a large portfolio," he says. "Our performance over the past year and a half has been more about not being in the right place at the best time," he says, meaning not making the right bet on European stocks when the region began to recover.
He says he believes the fund has turned a corner.
"We live in a financial world that idolizes complexity," says Manisha Thakor, who runs MoneyZen Wealth Management in Santa Fe, N.M. But don't be impressed by fancy jargon. She says some top-performing funds "are so clearly articulated, your 12-year-old child can understand the root logic."
She highlights Dimensional Fund Advisors' U.S. Core Equity 1 Portfolio, which has more than tripled in size and gone from a three-star Morningstar rating to a five.
"This fund's simple, powerful strategy is to own a broad range of U.S. companies with a tilt toward two dimensions—small and value companies—that have historically provided higher expected returns," she says.
"Turnover is low, at 2%, making the fund index-like," Ms. Thakor says, in the way it buys and holds shares for the long run.
Will Danoff, famous for his piles of financial reports and jotted notes, has been the manager of giant Fidelity Contrafund for the past 24 years. The fund, with more than $106 billion in assets, has retained a consistently solid star rating over the decade, dropping a notch from a five to a four.
When it comes to taking a new position in a firm, "we discuss with the companies the fundamentals [of their business]," says Mr. Danoff. "The more companies you listen to, the more opportunities you see. Woody Allen says 80% of life is showing up. I am the Woody Allen of Fidelity."
Funds with a balanced portfolio between bonds and stocks tend to retain steady ratings over time and can serve as "one-stop" shops for investors.
Of the 10 largest funds that kept their five stars for 10 years, three were balanced funds, according to an analysis by Mutual Fund Observer. And one of these success stories is Vanguard Wellington, which kept a ratio of roughly 60/40 between stocks and bonds as assets under management grew.
The other two balanced funds to make this group were American Funds Income Fund of America and American Funds American Balanced.
Todd Rosenbluth, director of ETF and mutual-fund research at McGraw Hill Financial Inc.'s S&P Capital IQ in New York, says there is a growing interest in balanced asset-allocation funds, such as Vanguard's fund, but warns that these funds have "a somewhat different risk profile" because of their varying degrees of exposure to bonds or stocks.
"More stocks tends to be higher-risk than less stocks. But also look inside at the type of stocks and bonds," says Mr. Rosenbluth.
Moderation seems to have paid off.
When a fund drops a notch, it doesn't necessarily mean it hasn't performed well. There are other factors to consider.
Morningstar points out that a fund's star rating can change because of new categories, new funds being added to the category, funds changing categories and such. Overall ratings are a weighted average of the three-, five- and 10-year ratings.
Scott Clemons, chief investment strategist of private banking at Brown Brothers Harriman in New York, emphasizes that ratings are backward-looking and say little about what will happen next.
The same can be said of recent returns. In the S&P Dow Jones study, an investor browsing at random through the 700-plus top-performing funds would have had less than a 1% chance of picking one of the two funds that was still in the top quartile four years later. (For the curious, the two were AMG SouthernSun Small Cap and Hodges Small Cap. ) The study included no index-tracking funds, exchange-traded funds, or specialized sector funds. S&P Dow Jones Indices is a unit of McGraw Hill Financial Inc.
Nevertheless, there are a few helpful questions investors can ask when looking at past performance, says Mr. Clemons. Among these: Is the same management team in place? How was the track record built? And if a fund had a great year, was it the result of "a lucky bet" or "a sign of some underlying strength?"
