Morningstar explains its new forward-looking rating system -- and tosses in some hot fund picks for good measure

Morningstar is clearly taking a risk with the new rating system. They are putting their money where their mouth is. The risk is hedged though. I have not yet seen the word “predict” in any of the many announcement emails and articles, but that is what they are doing. With the focus on subjective evaluation of mutual funds by talented analysts, they will, at the very least, add value through comment and color, which should be helpful to some investors and advisors. The biggest hedge in the Morningstar move is the fact that the accuracy of the system cannot be evaluated now. They are marketing the system incessantly with article after article. But, we won’t know if it works for years.

There are approaches to mutual fund prediction that have been documented as being effective. The web service MutualDecision began to track their recommendations showing some predictive capability. Unfortunately the site went out of business in early 2011. FundReveal has an approach that uses quantitative measurements focused on determining investment decision-making capability has been offering predictive service since its inception in 2009. A retroactive demonstration of the approach shows significant outperformance versus the S&P500 between 2000 and 2010. Full disclosure: I am a member of the FundReveal team. Only time will tell if the new service has predictive capability. We look forward to the evaluations that will be possible in a year or two when the necessary data is available.

Ah, so a financial services publisher has solved the problem of predicting the future! Likely a Nobel Prize in there somewhere.

“There are approaches to mutual fund prediction that have been documented as being effective.” Please provide independent, peer-reviewed evidence of this claim. Sales and marketing reports are not needed.

If this is such a robust and accessible deliverable, there must be vast amounts of independent (non-commercial) validation.

So if these remarkable (miracle) approaches that predict the future will take 1-2 years to validate whould investor’s money be trusted to them now?

Let’s take a flight of fancy and assume that Morningstar has been able to boldly go (etc.) offering consistently reliable, forward-looking ratings. Then what? It’s not like the insights would be a big secret that a privileged few could cash in on; quite the opposite. So then, once it became widely obvious they were right, wouldn’t everybody start relying on them and piling in to buy the alleged golden eggs and sell the rotten ones (or, for the contrarians, the reverse, but the same basic premise)? Wouldn’t this have to spell the demise of the anomalous goose shortly thereafter, based on the science of expected returns? Thus, even in the best-case scenario that the system were working now, it seems to me it wouldn’t work for long. And how would an investor know when it had stopped working, other than in hindsight? Hello, square one.