Morningstar Ratings
Morningstar Rating
The Morningstar Risk-Adjusted Rating brings both performance and risk together into one evaluation. To determine a fund's star rating for a given period (three, five, or 10 years), the fund's Morningstar Risk score is subtracted from its Morningstar Return score. The resulting number is plotted along 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 it 3 stars (Neutral or Average); those in the next 22.5% receive 2 stars (Below Average); and the bottom 10% get 1 star (Lowest). The star ratings are recalculated monthly.
Star ratings for closed-end funds are based on NAV rather than market-price total returns, not because market-price returns aren't important, but because they don't always reflect the returns fund managers deliver. Net asset value represents the performance of the underlying portfolio, net of expenses. Because the star rating is intended to incorporate fund-specific risk, not market risk, it makes sense to use NAV-based returns. In fact, the shorter the time frame, the more likely it is that a fund's NAV and market-price returns will diverge because of premiums and discounts. Funds that experience increased demand for their shares will have higher market-price returns if share prices rise faster than NAVs. Similarly, the market-price return of shares bought at a premium will be lower than the NAV returns if demand for the shares slows despite consistent NAV performance. Over time, the effects of premiums and discounts on returns tend to smooth out, and market-price and NAV returns converge to within a few points of each other. Thus, it's the performance of the underlying portfolio that really counts over time.
Morningstar Return
The Morningstar Return figure rates a fund's performance relative to other funds in its broad asset class based on total returns in excess of the 90-day Treasury-bill return. The Morningstar Return figure for a fund is listed relative to the average of its broad asset class, which is set at 1.00. A figure of 1.10 means that the fund's excess return over the Treasury-bill return was 10% better than the average excess return for its class average in the given time period. A score of 0.90 indicates that the fund's excess return was 10% below the class average.
To prevent near- or below-zero class averages, the T-bill return is used as a surrogate class average in cases where the average excess return is less than the actual T-bill return. Morningstar does not calculate a return score for any fund that has less than three-years of performance data.
Morningstar Risk
The Morningstar Risk statistic evaluates the fund's downside volatility relative to that of other funds in its broad asset class. Morningstar uses a proprietary risk measure that operates differently from traditional risk measures, such as beta and standard deviation, which see both greater- and less-than-expected returns as added volatility. Morningstar believes that most investors' greatest fear is losing money--defined as underperforming the risk-free rate of return an investor can earn from the 90-day Treasury bill--so our risk measure focuses only on that downside risk.
To calculate the risk score, we plot monthly fund returns in relation to T-bill returns. We add up the amounts by which the fund trails the T-bill return each month and divide that total by the period's total number of months. This number, the average monthly underperformance statistic, is then compared with those of other funds in the same broad asset class (domestic stock, international stock, taxable bond, or municipal bond) to assign our risk scores. The resulting risk score expresses how risky the fund is relative to the average fund in its class. The average risk score for the class is set equal to 1.00; a Morningstar Risk score of 1.35 for a taxable-bond fund means that the fund has been 35% riskier than the average taxable-bond fund for the period considered.
Note: Morningstar does not rate any fund that has less than three years of performance data.
Volatility Measurements
Standard Deviation
Standard deviation is a statistical measure of the range of a fund's performance. When a fund has a high standard deviation, its range of performance has been very wide, indicating that there is a greater potential for volatility.
The standard deviation figure provided here is an annualized statistic based on 36 monthly returns. By definition, approximately 68% of the time, the total returns of any given fund are expected to differ from its mean total return by no more than plus or minus the standard deviation figure. Ninety-five percent of the time, a fund's total returns should be within a range of plus or minus two times the standard deviation from its mean. These ranges assume that a fund's returns fall in a typical bell-shaped distribution.
Mean
The mean represents the annualized average monthly return from which the standard deviation is calculated. The mean will not be exactly the same as the annualized trailing, three-year return figure for the same year. (Technically, the mean is an annualized arithmetic average while the total return figure is an annualized geometric average.)
Sharpe Ratio
Our Sharpe ratio is based on a risk-adjusted measure developed by Nobel Laureate William Sharpe. It is calculated using standard deviation and excess return to determine reward per unit of risk.
First, the average monthly return of the 90-day Treasury bill (over a 36-month period) is subtracted from the fund's average monthly return. The difference in total return represents the fund's excess return beyond that of the 90-day Treasury bill, a risk-free investment. An arithmetic annualized excess return is then calculated by multiplying this monthly return by 12. To show a relationship between excess return and risk, this number is then divided by the standard deviation of the fund's annualized excess returns. The higher the Sharpe ratio, the better the fund's historical risk-adjusted performance.
Bear Market Decile Rank
This statistic enables investors to gauge a fund's performance during a bear market. As a standard measure, Morningstar compares all equity funds against the S&P 500 index and all fixed-income funds against the Barclays Aggregate Index . We add together a fund's performance during each bear-market month over the past five years to reach a cumulative bear-market return. Based on these returns, equity funds are compared with other equity funds and bond funds are compared with other bond funds. They are then assigned a decile ranking where the 10% of funds with the worst performance receive a ranking of 10, and the 10% of funds with the best performance receive a ranking of 1. Because Morningstar employs the trailing five-year time period for this statistic, only funds with five years of history are given a bear-market decile ranking.
Modern Portfolio Theory Statistics
R-Squared vs. Standard Index
R-squared ranges from 0 to 100 and reflects the percentage of a fund's movements that are explained by movements in its benchmark index. An R-squared of 100 means that all movements of a fund are completely explained by movements in the index. Thus, index funds that invest only in S&P 500 stocks will have an R-squared very close to 100. Conversely, a low R-squared indicates that very few of the fund's movements are explained by movements in its benchmark index. An R-squared measure of 35, for example, means that only 35% of the fund's movements can be explained by movements in its benchmark index. Therefore, R-squared can be used to ascertain the significance of a particular beta or alpha. Generally, a higher R-squared will indicate a more useful beta figure. If the R-squared is lower, then the beta is less relevant to the fund's performance.
Beta vs. Standard Index
Beta, a component of Modern Portfolio Theory statistics, is a measure of a fund's sensitivity to market movements. It measures the relationship between a fund's excess return over T-bills and the excess return of the benchmark index. Equity funds are compared with the S&P 500 index; bond funds are compared with the Barclays Aggregate Bond index. Morningstar calculates beta using the same regression equation as the one used for alpha, which regresses excess return for the fund against excess return for the index. This approach differs slightly from other methodologies that rely on a regression of raw returns.
By definition, the beta of the benchmark (in this case, an index) is 1.00. Accordingly, a fund with a 1.10 beta has performed 10% better than its benchmark index—after deducting the T-bill rate—than the index in up markets and 10% worse in down markets, assuming all other factors remain constant. Conversely, a beta of 0.85 indicates that the fund has performed 15% worse than the index in up markets and 15% better in down markets. A low beta does not imply that the fund has a low level of volatility, though; rather, a low beta means only that the funds market-related risk is low. A specialty fund that invests primarily in gold, for example, will often have a low beta (and a low R-squared), relative to the S&P 500 index, as its performance is tied more closely to the price of gold and gold-mining stocks than to the overall stock market. Thus, though the specialty fund might fluctuate wildly because of rapid changes in gold prices, its beta relative to the S&P may remain low.
Alpha vs. Standard Index
Alpha measures the difference between a fund's actual returns and its expected performance, given its level of risk (as measured by beta). A positive alpha figure indicates the fund has performed better than its beta would predict. In contrast, a negative alpha indicates a fund has underperformed, given the expectations established by the fund's beta. Some investors see alpha as a measurement of the value added or subtracted by a fund's manager. There are limitations to alpha's ability to accurately depict a manager's added or subtracted value. In some cases, a negative alpha can result from the expenses that are present in the fund figures but are not present in the figures of the comparison index. Alpha is dependent on the accuracy of beta: If the investor accepts beta as a conclusive definition of risk, a positive alpha would be a conclusive indicator of good fund performance. Of course, the value of beta is dependent on another statistic, known as R-squared.
For Alpha vs. the Standard Index, Morningstar performs its calculations using the S&P 500 as the benchmark index for equity funds and the Barclays Aggregate as the benchmark index for bond funds. Morningstar deducts the current return of the 90-day T-bill from the total return of both the fund and the benchmark index. The difference is called the fund's excess return. The exact mathematical definition of alpha that Morningstar uses is listed below.
Alpha = Excess Return - ((Beta x (Benchmark - Treasury))
Where:
Benchmark = Total Return of Benchmark Index
Treasury = Return on Three-month Treasury Bill