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As a mutual fund investor, you don’t want to pay “the stupid penalty.”

That’s what Russel Kinnel calls the difference between the best and worst funds. It’s a penalty that he’s studied closely as director of mutual fund research at Morningstar.

Consider Morningstar’s analysis of the best and worst large-cap mutual funds over a 10-year stretch ending in April 2008. Investors who put $100,000 in the best large-cap blend funds ended up with an average profit of $97,000. Investors in the worst funds pocketed just $33,000. That makes for a stupid penalty of $64,000 — a price you don’t want to pay.

“Stupid” may be a bit harsh, because it’s not always easy to determine whether one fund is more likely to produce above-average returns year after year.

That’s where various fund ratings systems come in. They can help simplify the selection process by serving as a starting point.

Morningstar and Lipper are the biggest players when it comes to tracking mutual fund performance. Their rating systems and performance rankings are widely used in the industry.

Methods differ

There’s a lot more at stake in selecting a fund than in choosing a movie, so you don’t want to rely solely on 1- to 5-star ratings. The rating services aren’t as subjective as film critics, but methodology differences can leave investors confused.

For instance, the same mutual fund can be classified differently depending on the research firm. Take Encompass (ENCPX), a fund that takes a go-anywhere approach, venturing into U.S. and international stocks of companies large and small.

In 2008 the fund finished down 62 percent. When the market rebounded last year, Encompass surged 137 percent — topping more than 200 funds in its category. This year, it’s again among the leaders, up nearly 16 percent.

Morningstar’s 5-star system gives Encompass just two stars, penalizing the fund for volatile returns. In contrast, the fund looks comparatively good using Lipper’s system, which rates funds on a scale of 1 to 5 for five different measures. Lipper gives Encompass a top-notch 5 in two categories, and 4, 3 and 1 in the others.

One reason for the differences: Morningstar categorizes Encompass as a world stock fund. Lipper classifies Encompass as a global multi-cap growth fund.

The category differences are important because a fund’s performance is measured against its peers. Choosing which group to compare against can have big implications for performance rankings.

John Rekenthaler, vice president of research at Morningstar, acknowledges star ratings are only an introduction to a fund that can “get the odds in your favor” but don’t ensure success. 

There will never be a perfect system for predicting fund performance. A key problem: Most ratings are backward-looking, relying on quantitative analysis that may offer little help predicting future performance. They don’t account for fund manager changes, how much managers invest in their own fund, and any number of intangibles.

A look at several trackers

Yet there’s no shortage of attempts to devise better ratings. New challengers to Morningstar and Lipper are emerging.

Here are key differences among the two largest and the smaller players in the fund-tracking business:

Morningstar: Its star ratings measure a fund’s past performance while also weighing how much risk a fund took to achieve its returns. A fund that produced top results won’t necessarily secure a top rating if its performance was unusually volatile.

Funds charging lower fees are more likely to get higher star ratings. In fact, a recent Morningstar study found that expenses, taken alone, are a slightly more important factor in predicting how well a fund will perform than star ratings.

Morningstar analysts also write fund reports, offering subjective evaluations of such factors as the fund’s managers or shifts in investment style.

Access to the reports is limited to premium members paying $179 a year or $19.95 a month. Funds that analysts deem likely to consistently deliver strong returns win Morningstar’s ‘Analyst Pick” designation.

Lipper: Uses criteria similar to Morningstar’s, but with a 1-to-5 number rating showing how well a fund meets specific goals. Lipper’s numbers show how a fund stacks up on five criteria: total return, consistency, expenses, tax efficiency and ability to minimize risk of losses in a variety of markets. The company’s Lipper Leaders are funds ranking among the top 20 percent of their peers.

Lipper’s reliance on a fund’s ability to protect investors from paying taxes on investment gains is another key difference. Morningstar’s site offers data on a fund’s tax efficiency, but it’s not figured into its star rating. Investors holding mutual funds in taxable accounts will want to pay close attention to those tax-efficiency rankings.

Standard & Poor’s: S&P changed its fund-ranking methodology last year, differentiating itself from Morningstar and Lipper. Like the others, S&P examines a fund’s record and risk level.

But S&P also analyzes a fund’s holdings. Portfolio quality is a judgment based on S&P analyst assessments of outlooks for individual stocks, and S&P’s credit rankings for bonds.

Other factors being equal, a fund holding stocks earning high marks from S&P will rank higher on its 5-star scale than one with poorly-rated holdings. It’s an attempt at a forward-looking approach for evaluating funds. But its predictive power hinges on S&P analysts’ assessment skills.

U.S. News & World Report: The magazine aggregates rankings from five services to arrive at a composite score for a fund, on a 1 to 10 scale. U.S. News gives equal weight to Morningstar, Lipper and S&P as well as Zacks Investment Research and TheStreet.com.

Zacks Investment Research: Assigns a score of 1 to funds considered a “strong buy” down to 5 for “strong sell.” The rankings are similar to S&P’s approach, assessing the quality of a stock fund’s holdings. That quality is determined according to Zacks’ system for ranking stocks.

FundReveal: A newly launched service founded by Ani Chitaley, formerly a vice president at Fidelity Investments. Investors can compare similar funds to see how returns differ, and the risks taken to achieve returns. A graph shows where each fund falls within a four-square quadrant, while also comparing against the Standard & Poor’s 500 index. The best funds appear in a quadrant signifying high returns with low risk.

—AP