Star Struck

This week I am happy to post an entry from our recent hire Zach Scott. You know you are building something special when a new member of the team buys into the culture of the firm so quickly. The Kool-Aide must be strong here!

Enjoy.

 

I admit it. I’m a college hoops junkie. And when my team is competitive, I can’t get enough. Even during the off-season I’ll scroll eagerly through websites, trying to figure out whether or not the latest recruit has decided to commit to my team and lead us to glory on the hardwood. And when a coveted high school player, or, in the terminology of high school sports ratings agencies, a “five-star recruit”, accepts a scholarship to play for my team, I get weak in the knees. I will start imagining wild scenarios, and even the most far-fetched speculation starts to seem plausible. I completely forget that these kids are 18-year olds who have yet to play a single game at the collegiate level.

That’s why, while watching the Super Bowl last week, I was intrigued by a statistic one of the announcers cited during the course of the game. Speaking about the ratings system used to gauge high school football players, the announcer, Al Michaels, stated that neither team’s starting lineup featured a single athlete deemed a “five-star recruit” upon high school graduation. And as far as four-star recruits are concerned, only seven players in the starting lineups of both teams were rated that highly. In fact, Seattle’s star quarterback, Russell Wilson, was only a two-star recruit coming out of high school, according to some ratings agencies, and yet, if not for one questionable throw at the end of the game, he would likely be considered one of the most successful NFL quarterbacks of the past decade.

The ratings system used to evaluate high school basketball and football athletes is a lot like the one used by investment fund ratings firms. One of the more popular firms, Morningstar, uses the same star system to evaluate five- and four-star funds (the two highest possible ratings). The only problem is that its ratings system’s predictive value, much like that for high-school athletes, has not, for the most part, adequately anticipated success. For instance, in his book The Only Guide to a Winning Investment Strategy You’ll Ever Need, Larry Swedroe cites a study by The Hulbert Financial Digest that tracked the performance of five-star funds (as rated by Morningstar) for an eight-year period between 1993-2000. According to the study, the total return on Morningstar’s five-star funds averaged 106 percent, while the total stock market, as measured by the Wilshire 5000 Equity Index, returned 222 percent over the same period of time. Even John Rekenthaler, editor of Morningstar Mutual Funds, is quoted in Swedroe’s book as stating that the star rating system is “just a way to sort funds according to past success.” In other words, the ratings given by Morningstar are entirely retrospective; they are not indicative of a fund’s future success.

My point isn’t to demean the ratings agencies. Clearly, there are highly-touted high school athletes and investment funds that live up to the hype based on their past performance. But these tend to be the exception, not the norm. Much like a college team’s success is unlikely to rise or fall based on a single player’s past performance, successful investment portfolios are more often than not diversified in nature and consist of carefully selected investment vehicles that have been evaluated in relation to a particular investor’s individual circumstances.

While there’s a certain allure to seeing how the unpredictable will be quantified, any good sports fan knows that just because your team obtains the five-star athlete, that’s no shoe-in for a successful season.