Understanding M*’s Star Rating

If you are a mutual fund investor, chances are you have seen Morningstar’s star rating every where, on fund family’s website, on Yahoo! Finance (where you can find a comprehensive list of funds and fund families), even on funds’ ads. Common sense tells us a fund with five stars should outperform a two-star fund, the same as we believe five-star hotels are better than three-star hotels. In deed, Morningstar’s own study in 2005 found that in general five-star funds did deliver superior performance than low star rating funds.

I remember when I first started building my mutual fund portfolio in 2001, the first thing I looked at was how many stars a fund carried. Yes, before I had any idea about a fund’s return, assests, manager, and cost, the stars told me whether a fund was “good” or “bad.” Since then, Morningstar has restructured its rating to more accurately judge a fund’s performance. Today, I read an article on Kiplinger’s Personal Finance about Morningstar’s rating system and decided to get a little bit more about the stars.

To begin with, we should know that Morningstr’s star rating is risk-adjusted rating, i.e., the star system is not just a reward for returns, but also takes into account the fund’s volatility and the cost of owning the fund. Also, a fund has to exist for at least three years before any star is assigned. The two major pieces of the rating system are:

Category based rating:

Since the restructuring in 2002, Morningstar now rates funds in 48 different categories, rather than the original four ranking groups: domestic equity, international equity, taxable bond, and municipal bond. With the new rating system, Morningstar assigns stars to a fund by comparing the fund against its peer in the same category rather than across the board. Therefore, a large-cap fund manager, who invests in large-cap companies which are considered less risky than small companies, has to beat his/her colleagues in the same arena by either producing higher returns or taking less risk to earn a higher start rating. Category-based rating makes the comparison fair.

Risk measurement:

Morningstar used to access the risk of a fund by comparing its average performance against the return of 90-day Treasury bill. The fund is seen as safe if its return is higher than T-bill; otherwise, the fund is risky. Therefore, no matter how volatile a fund is in the short term, it is considered safe as long as it outperforms T-bill. Under the current rating system, Morningstar accesses a fund’s performance variation on a monthly basis and takes the variation into account when measuring the risk factor of a fund.

While the star rating provides a convenient tool, an investor should look beyond a fund’s star when making an investment decision. Unlike enjoying the luxury of a five-star hotel for a couple of nights, a mutual fund as a long-term investment vehicle will stay with you for years to come. When facing a choice of adding which fund to you portfolio, a fund’s other factors, such as expense ratio, turn-over ratio, fund size, manager’s tenure and tracking record, and asset allocation, should not be ignored. For example, mutual fund giant Vanguard is known for its wide selection of low cost index funds and many investors build their entire portfolio with Vanguard funds (the “lazy� portfolio). After I checked about 100 Vanguard mutual funds that are available to individual investors, I found only 12 of them have five stars.

As Morningstar repeatedly told investors, the star rating is a tool for the initial research, not the finishing touch.

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