What Is the Definition of Morningstar Rating and How to Use It
Morningstar, Inc. is an American publicly traded company that provides independent investment research, data, and rating services to individual investors, financial advisors, asset managers, and retirement plan providers.
The Morningstar rating system is available in two forms:
- Star System – This system uses a one to five-star rating, with a five-star rating being the best.
- Medal System – This system awards Gold, Silver, and Bronze medals to funds. Medals are awarded based on how a fund has performed in the past five years compared with all other funds in its category.
The star system is the most common form of the Morningstar rating. The ratings are based on an analyst’s assessment of a fund’s past risk and return performance relative to its peers.
The rating is designed to reflect the risk-adjusted return of a fund.
It attempts to identify funds that have provided the highest level of consistent returns given their level of risk, or are most likely to provide strong risk-adjusted returns in the future.
How Does the Morningstar Rating Work?
The Morningstar rating system uses a proprietary algorithm to calculate ratings for more than 7,000 funds in the US.
In this case, 30-day returns from the past three years are compared to those for other stock funds in their categories.
Morningstar analysts calculate a risk-adjusted return by assigning a weight to both volatility and the amount of money that investors have actually lost in a fund, known as downside deviation.
After taking these into account, analysts compare a fund’s returns against a peer group of similar funds. The star rating is then assigned based on how the fund performed relative to the average fund in its category.
Interpreting Morningstar Ratings
Morningstar rates funds on a one-to five star scale.
Five stars is the best rating that can be assigned to a fund, denoting that the fund has outperformed 90% of funds in its category on both an absolute and risk adjusted basis over time.
One star is the lowest rating that can be assigned to a fund, which means it has underperformed 80% of funds in its category on an absolute and risk adjusted basis.
Morningstar calculates performance at different time periods depending upon the type of investment: 1 year, 3 years, 5 years and 10 years.
The difference between the best and worst rating is also significant: funds with 5 stars receive a top ranking and outperformed their peers by 1.5% on an annualized basis over the past decade as of February 2011.
Whereas funds with one star received a bottom ranking and underperformed their peers by 2.5% on an annualized basis over the past decade as of February 2011.
How To Use Morningstar Ratings
Morningstar ratings can be used when making two types of investment decisions: buying individual stocks and picking mutual funds.
When buying an individual stock, Morningstar’s star rating can help you determine a fund’s riskiness. A five-star rating is the best indication that a stock is less risky than its peers, while a one-star rating is the worst.
For mutual funds, Morningstar’s star ratings can help when choosing between similar alternatives in terms of risk and return. When all else fails, go with the fund that has five stars.
While this might not always yield great returns, it probably means that it has performed better than its peers over time.
On the other hand, a fund with one star is riskier than its peers on average; avoid it if there are better alternatives in the same category.
Example of Morningstar Ratings
Assume that an investor is interested in investing in a large-cap growth fund. In order to narrow down the choices, the investor could use Morningstar’s ratings to find the best-rated funds in that category.
Morningstar rates the large-cap growth category from one to five stars, with a five-star rating indicating that the fund has outperformed 90% of funds in its category on both an absolute and risk adjusted basis over time.
The investor could then further research the five-star rated funds to find the one that best suits his or her individual needs.
How Reliable Are Morningstar Ratings?
The Morningstar rating system is one of the most popular ways to measure a mutual fund’s performance, but it is not without its flaws.
Critics argue that the star rating system is too subjective and that it does not take into account all of the risks associated with investing.
Morningstar ratings are also backward-looking and do not necessarily predict how a fund will perform in the future.
Nevertheless, Morningstar ratings are one of the best ways to compare different mutual funds and to get a sense of a fund’s overall riskiness.
The Bottom Line
Morningstar’s star ratings are assigned based on the fund’s performance relative to its peers over time.
When making an investment decision, it is always important to do your own research and to consult with a financial advisor.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.