Often simply called the Star Rating, the Morningstar Rating brings performance (returns) and risk together into one evaluation. To determine a fund's star rating for a given time period (three, five, or 10 years), the fund's Morningstar Risk Score is subtracted from its Morningstar Return Score. The result is plotted on a bell curve to determine the fund's rating for each time period: If the fund scores in the top 10% of its broad asset class (domestic stock, international stock, taxable bond, or municipal bond), it receives 5 stars (Highest); if it falls in the next 22.5% it receives 4 stars (Above Average); a place in the middle 35% earns 3 stars (Neutral); those lower still, in the next 22.5%, receive 2 stars (Below Average); and the bottom 10% get only 1 star (Lowest). Also see Morningstar Rating Broad Asset Classes.
Morningstar recognizes that no rating system can take into account all factors that one must consider before deciding to invest in a mutual fund. The Morningstar Risk-Adjusted Rating is intended as a way of identifying funds that have produced the highest level of returns relative to the risks they’ve taken. Investors should keep in mind that while it serves as an initial screen, the rating is only the first step toward a more comprehensive evaluation.
Morningstar generates this data in-house.
Example
As of January 1998, First Financial’s performance had been strong. It had been rated 104 months, had an average star rating of 3.5, and had a current star rating of 5 stars. In contrast, at the same time, ASA Limited’s weak performance gave it much lower ratings. It had been rated for 156 months, and had an average rating of 1.3 and a current rating of 2 stars.
The Morningstar Return figure puts a fund’s returns in context of a risk-free rate. The Morningstar Return figures also reflect the effect of loads (unlike regular total return figures).
About Morningstar Risk
Listed for three, five, and ten years, this statistic that evaluates the fund’s downside volatility relative to that of others in its broad asset class. To calculate the Morningstar Risk score, we plot fund's monthly returns in relation to T-Bill returns. We add up the amounts by which the fund fell short of the Treasury bill’s return and divide the result by the total number of months in the rating period. This number is then compared with those of other funds in the same broad asset class. The resulting risk score expresses how risky the fund is, relative to the average fund in its asset class. The average risk score for the fund’s asset class is set equal to 1.00; thus a Morningstar risk score of 1.35 for a taxable-bond fund reveals that the fund has been 35% riskier than the average taxable-bond fund for the period considered.
Although Morningstar ratings are objective in the sense that they are influenced by neither economic forecasts nor subjective opinions of a fund manager’s current strategy, the biases employed in designing the system should be understood. Morningstar works on the assumption that investors are reluctant to assume added risks unless they are compensated for such ventures. Low risk and high returns are rewarded equally. Accordingly, Morningstar’s system tends to favor all-weather funds, which tend to perform consistently over time.
In a sense, Morningstar’s rating system assumes that each fund is the only position in an investor’s account. On that basis, it clearly makes more sense to hold a 5-star all-weather fund than a volatile 1-star precious-metals fund. That doesn’t suggest, however, that the lower-rated fund is without merit—in this case, the fund simply isn’t designed to be an all-weather holding. Accordingly, there can be reasons to hold a low-rated fund. It all depends on an investor’s goals and the other holdings in their portfolio.
Not all 5-star funds are automatically all-weather funds, either. For example, a young three-year old fund may have begun at exactly the right time to benefit from certain market conditions, while never having been tested in an unfavorable market. Similarly, a high-yield bond fund with the same inception date has only been around long enough to see strength in its sector. A 5-star rating on such a fund, however, doesn’t reflect how the fund might have reacted when high-yield bonds fell severely out of favor in 1989 and 1990.
The ratings do help to distinguish between funds that can be used as core, stable holdings and those funds that promise more volatility. Even for a precious-metals portfolio, the ratings are useful. While no gold fund is likely to be a 5-star fund, the ratings can help distinguish between a riskier 1-star fund and a 2-star fund that will give a smoother, if still lively, ride. Morningstar’s ratings make clear such important distinctions, helping to ensure that investors get the characteristics they want.
Recognizing the Limitations of the Morningstar Risk-Adjusted Rating
Recognizing the limitations of Morningstar’s basic rating system (or those of any quantitative system, for that matter) is highly useful. Morningstar’s ratings have validity but no quantitative system is infallible. Still, as a first-level screen supplemented by a wealth of fundamental information, the ratings work exceedingly well if investors treat them in the spirit intended. Any mutual-fund tracking service can tell you which managers are on a winning streak; for example, Principia can generate customized lists of top performers. But Morningstar’s rating system tries to do something more: It identifies those funds that have been the most satisfying holdings —ones that investors can hold long enough to reap their rewards. High-risk funds may encourage buying at peaks, resulting in several years of waiting just to get back to par. Moreover, volatile funds also encourage the related evil of selling in valleys, because shareholders, when disenchanted with underperformance, often sell lagging funds before a rebound. Morningstar’s system emphasizes steadier, more farsighted investing, the kind that is most likely to lead to significant long-term profits for shareholders.
Not A Prediction
In the Morningstar rating system, a low-risk/low-return fund and a high-risk/high-return fund could achieve identical average ratings (3 stars). The individual components of risk and return are especially important in such a case, because these two funds would have very different purposes despite their equal ratings and, based on historical precedent, should produce returns that would adequately reward an investor for the risks incurred.
Recognizing its descriptive—rather than predictive—nature is essential in understanding the rating system. A fund’s rating doesn’t change because a fund’s potential has somehow diminished or improved. The system is purely quantitative; a rating change simply reflects the change in a fund’s historical record of risk and return relative to its competitors’. Because Morningstar bases these evaluations on trailing performance records, a change in rating could be explained by a time period that drops out of consideration as well as one that is added.
That the Morningstar rating system doesn’t lay claim to some magical methodology for predicting future returns differentiates it from the systems of many investment publications. The absence of forecasts, from the Morningstar point of view, is a strength, not a weakness. Investors can bring their own opinions—and not subjective criteria on the part of Morningstar—to the table. Therefore, even if a person disagrees with the opinions put forth in a Morningstar fund analysis, the rating still serves as a useful evaluation tool. Offering an objective measure of each fund’s historical performance and risk and providing relevant data—portfolio statistics, composition, sector weightings, and so on—is Morningstar’s goal. Having this information helps investors to determine if the fund’s current positioning fits with their goals. To impose opinions on the basic rating structure could easily cloud that process.