How To Interpret Morningstar Ratings?

Answer 1

For mutual fund investors looking for every piece of information available to help choose the best investment out there, the Morningstar rating can be crucial.

Morningstar offers a fairly straightforward one- to five-star rating for thousands of mutual funds and it seems fairly intuitive to use the rating to find the best funds. Just look for five star funds, right? That certainly sounds reasonable enough but it helps to understand how the ratings are calculated.

Morningstar ratings are a measure of the risk-adjusted performance of a mutual fund. Mutual fund returns are calculated on a three, five and ten year period and then adjusted for the risk taken to achieve those returns. Funds are then grouped according to their stated investment objective. Therefore, categories such as large cap growth funds get measured against each other while other groups such as international and value funds get compared to their own kind.

Once similar-minded funds are grouped and rated, star ratings are assigned according to a bell shaped curve. The 10% of funds with the highest risk adjusted returns receive a five star rating. The next 22.5% receive a rating of four stars. The middle 35% get a three star rating. The next 22.5% receive two stars and the bottom 10% get the lowest one star rating.

It's important to note that a Morningstar rating can be a useful tool when looking for relative out performers within a rating group but don't expect to find the highest returns by picking any five star fund. Funds with a five star rating are the best within a group but if the category as a whole underperforms the market you may find, as an example, a fund with a 5% average annual return topping the charts. Conversely, in an outperforming sector, an annual return of 10% might put you at the bottom of the barrel.

When evaluating mutual fund performance, the Morningstar rating can be a great help but make sure you know what you're working with before you act.