What's Behind the Morningstar Rating?

We take a closer look at the Morningstar Rating system for funds and how it should be used.
By Morningstar Analysts |  05-07-11 | 
 

Finding the right investments can be a daunting process. To help alleviate the burden of choice overload, Morningstar has created an array of tools to help investors assess an investment's key characteristics at a glance.

The Morningstar Style Box for mutual funds, for example, helps you quickly see how a fund actually invests the bulk of its assets. Meanwhile, the Morningstar Rating for funds (commonly called the "star rating"), introduced in 1985, helps investors quickly gauge how a fund has balanced risk and reward.

Star Rating for Mutual Funds

Snapshot

Morningstar's star rating for funds measures how well a fund has balanced risk and reward relative to its peers. Keep in mind that fund star ratings are strictly returns-based and don't take into account fund fundamentals, such as manager changes.

How It's Calculated

The star rating for funds is strictly quantitative--meaning that our analysts' opinion of a fund has no bearing on its star rating. (Note: Morningstar has also  rolled out qualitative Analyst Ratings for funds, however.) Instead, a fund's rating is based on its performance versus its peers' during the past three-, five-, and 10-year periods. A fund must have at least a three-year track record to be eligible for a star rating.

The return component of the rating is fairly straightforward, taking into account the fund's return during each month over the past three-, five-, and 10-year periods and reducing that return to account for any expenses investors would've had to pay. Because investors always have an option to invest at the risk-free rate, Morningstar measures only the amount by which fund returns have exceeded that risk-free rate.

The risk component of the rating is based on "expected utility theory," which recognizes that investors are more concerned about potential losses than unexpected gains and are therefore willing to trade some fraction of their expected return in exchange for a greater certainty of return. Thus, the risk measure penalizes funds more when they exhibit downside volatility versus a risk-free rate of return than it does when they exhibit upside volatility. However, to help reduce the possibility of strong short-term performance masking the inherent risk of a fund, the rating accounts for all variations in a fund's monthly performance during the past three-, five-, and 10-year periods, not just the downward variations.

Once we've arrived at a fund's risk and return scores, funds are then ranked and rated within their Morningstar categories for each time period, with stars assigned on a bell curve scale. For example, we would evaluate a small/mid-cap fund by comparing how it has performed relative to other funds in the small/mid-cap category. The bottom 10% of the funds in the category are given a 1-star rating, the next 22.5% get a 2-star rating, the next 35% get a 3-star rating, the next 22.5% get a 4-star rating, and the remaining 10% get a 5-star rating. Funds receive star ratings for each time period (three-, five-, and 10-year), and the overall star rating is a weighted average of the different time periods, with an emphasis on the longer-term ratings. As such, the star rating favors funds that have consistent long-term track records. We recalculate funds' ratings every month.

How to Use It (and How Not to)

The most prudent way for investors to use the star rating for funds is to help narrow down the pool of investment options. For example, Morningstar subscribers could use the Fund Screener to seek out say, large-cap funds with below-average risk, and star ratings of at least 3, thereby winnowing down their choices to a more manageable group of funds worthy of further research.

On the flip side, the star rating should never be used as the be-all and end-all metric for identifying superior funds. While our research shows that 5-star rated funds largely outperform 1-star rated funds, keep in mind that these ratings are based on historical returns and are not reliable predictors of future performance. Also note that every category has 5-star rated funds, but not all categories are equally suitable for most investors. A 5-star technology sector fund might make sense for only a small population of investors, while a 5-star large-cap fund might make sense for most investors.

Finally, let’s not forget that investing is a personalised activity. Hence, at this stage, investors would do well to seek advice from their investment advisors/financial planners to identify funds that are best suited for them.

The article first appeared on Morningstar.com, our sister US site and has been formatted for India.

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