Morningstar assigns star ratings to mutual funds based on their historical risk-adjusted returns compared to peers in the relevant category.
What is the star rating? What is it not?
The star rating is a handy visual measure of a fund's overall performance and gives a compelling insight into how it has done after accounting for the risk taken and costs, compared to other funds in the same category.
What is the star rating not? It's not an outright buy or sell recommendation (though evidence exists star ratings do have some predictive powers) but a quantitative indicator of how a fund has done historically.
A high star rating may imply investors should explore them closely and could use the ratings as a first-level filter while screening funds.
The Morningstar rating is initiated on all funds that have completed three years in existence--assuming they have a sizeable peer category to compare with--and the rating is reviewed at the end of each month after accounting for the previous month's performance. (Read the complete rating methodology here.)
The five-star club
Of the 264 mutual funds available to investors under the Morningstar Large-Cap and Small and Mid-Cap categories (after eliminating the institutional-only funds and listing only the 'growth' share class), there are only 20 funds that get the five-star rating.
You can use the Morningstar Fund Screener to run a customized search for such lists.
Here we profile four funds that completed three years recently and attained a five-star rating, implying strong risk-adjusted returns compared to their category over the timeframe.
Mirae Asset India Opportunities Retail
Fund inception: 04/04/2008
Fund size: Rs 2.3 billion
The large-cap fund has thrived under the management of Gopal Agrawal and Neelesh Surana, returning 28.22% annualized over a three-year period, beating its benchmark and peers by 11.75% and 11.22%, respectively, and achieving the third rank in a category of 330 large-cap funds.
In a recent interview with Morningstar, Agrawal said the fund invests about 75%-80% of assets in long-term equity holdings while 20% is a tactical portion which is invested where he sees opportunities.
The fund impresses with its ability to do well in both rising and choppy markets with an above-average upside-capture ratio (ability to capture a rising market's gains) of 110.89 over the three-year period while also having a low downside-capture ratio of 77.65.
Morgan Stanley A.C.E.
Fund inception: 04/03/08
Fund size: Rs 3.0 billion
Launched in early 2008, the large-cap fund from the Morgan Stanley Mutual Fund stable has done well over a three-year period, logging returns of 23.88% while the benchmark and the average peer delivered 7.42% and 7.28% less.
Combining both top-down and bottom-up approaches, manager Jayesh Gandhi does not shy away from being benchmark-agnostic and taking meaningful bets on stocks and sectors.
ICICI Prudential Focused Bluechip Equity Retail
Fund inception: 05/23/2008
Fund size: Rs 38 billion
The large-cap fund from ICICI Prudential AMC, under the stewardship of former manager Prashant Kothari, clocked the ninth best return in a category of 330 funds over a three-year period.
The fund is also an example of when the star rating may not show the complete picture, where events such as a management shake-up may warrant an investor to look beyond the ratings.
Accordingly, Morningstar's qualitative ratings, the Analyst Rating--which is our forward-looking view on a fund's prospects to outperform peers over the long haul--has been downgraded to Neutral from Bronze earlier. (You may look up the complete list of funds under Analyst Ratings coverage here.)
Religare Mid & Small Cap
Fund inception: 03/17/2008
Fund size: Rs 173.1 million
The only Mid and Small Cap fund on the list, the Religare offering has delivered 'High' returns after taking on 'Below Average' risk, according to Morningstar's measures.
How did it do it? By keeping volatility low and not just beating the benchmark and peers in rising markets (it gained 34.69%, compared to the average peer's 17.2% returns) but also falling far less than others in a down market (the fund lost 19.24% in 2011 while the benchmark was down 31%).