Morningstar Fund Ratings and Millennial Investors (Plus Tax Planning)

This year is getting away from me. October is my favorite month of the year and I'm a bit sad to see it gone. November is here and it's time to start year-end tax planning.


I'm hosting a webinar for retirees on Year End Tax Planning Strategies next Friday and if you're retired, or retirement age, you should check it out. I'll be covering tax strategies that you won't hear from most other advisors. You can sign up here.


So what did I read this week?


I had a conversation with a prospective client earlier this week who mentioned that they base their mutual fund choices on Morningstar ratings. This reminded me of an article I read a while back which showed empirically that Morningstar ratings are mediocre at best when it comes to predicting future returns. I'll link the article below, but essentially, Morningstar ratings measure historical returns, without any expectation of predicting future returns. When viewed with a multi-year time frame, the majority of funds have lower ratings after a few years. This could be due to the increased flows or any number of reasons.


So how should you choose the funds for your portfolio? The short answer is you should probably stay away from mutual funds. Exchange Traded Funds, or ETF's, are better options for most investors. Index ETF's have several benefits.

  • You don't have to worry about the fund underperforming the index from year to year.

  • They're more tax-efficient. Mutual funds can have taxable gains, even in years the fund loses money, like 2018.

  • Expenses are often significantly lower. Expenses matter and you shouldn't pay extra for a fund that doesn't match its benchmark.

You might be thinking that I'm ignoring index mutual funds, and you're right. For most investors, index ETF's are better options because they trade commission-free on most platforms.


So when do I prefer an actively managed fund? Research shows that active management is beneficial in bonds, so I use mutual funds in that space. I can go into the boring, technical answer (overweight government bonds, sampling an index isn't as efficient in the larger bond universe), but essentially it just doesn't work as well for managing yield or risk. So I go with active managers in this space who are able to follow value.


I'll talk more about how to build a portfolio using asset allocation in the future.


The Morningstar Mirage


Expectations are a funny thing. If someone expects a 25% return and only makes 15%, they'll probably be disappointed. The flip side to that is if someone expects a 10% return and makes 15%, they'll probably be pretty happy. Right now, there are two cultural approaches to the market, each with very different expectations.

  • Old school investors are primarily investing for long-term growth. 10% average annual returns are solid and will lead to wealth creation over a lifetime of saving.

  • Millennials and Gen Z have higher expectations. These investors are fine with risk and have jumped into NFT's, meme stocks, and other speculative investments. They hope their investments go to the moon and most aren't satisfied with traditional portfolios, which they see as boring.

So my question is what caused this divide. There are plenty of explanations, but the one I find most plausible is that younger investors were buoyed by last year's stimulus checks, which they put towards investing. Couple this with a zero yield world in which everyone is becoming more aggressive while searching for yield and you have the beginnings of a movement. These retail investors, while not controlling large amounts of money, have coordinated their actions through Twitter, Reddit, and Discord to great effect.


Will the future be controlled by traditional investors or the new breed, willing to YOLO on anything? My expectation is that as younger investors begin to build real money, they'll embrace traditional finance. Once stakes rise, they will be willing to trade significantly lower risk for lower returns. The flip side to that is that they will probably still keep a portion in the risky assets which created their wealth.

“The only thing that matters is where you are in the long run,” Howard Marks


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