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Each month we provide Morningstar Ratings on funds
in the Morningstar
500
. If a fund’s star rating has
changed, we add a little down arrow or up arrow to
tell you the direction of the change.
I often get questions about why a rating has changed,
so I’ll provide a rundown here.
The Morningstar Rating for funds is a purely quantita-
tive measure of risk-adjusted (and load-adjusted)
performance. It reflects a fund’s performance over
trailing periods of three, five, and
10
years relative
to its peer group. (Peer groups are categories like
foreign large-blend or high-yield bond.) Although
some people have the impression that star ratings
reflect analyst opinions, our fund star rating is
a purely objective reflection of past performance,
updated once a month.
To produce the star ratings each month, we calculate
every fund’s risk-adjusted return for each applicable
time period. This is done by applying a “risk penalty”
to each fund’s returns based on expected utility theory,
a commonly used method of economic analysis. (The
theory assumes that investors are willing to sacrifice
a little return in exchange for greater certainty.)
This creates a curve measuring incremental changes
in risk and return. Variation in monthly performance
in either direction is penalized, but downside volatility
receives a greater penalty.
By design, this risk-adjusted return rewards consis-
tent performance. We know that investors do much
better using consistent funds than those that swing
wildly from one extreme to the other, particularly in
cases of extreme losses.
We look at a fund’s Morningstar Return and
Morningstar Risk ratings to see where they land on
the utility function curve. Essentially, this measures
how well the investor is compensated for the riski-
ness of the fund. Next, we rank all of the funds in a
category from best risk-adjusted return to worst.
The top
10%
receive
5
stars, the next
22
.
5%
receive
4
stars, the next
33%
receive
3
stars, the next
22
.
5%
receive
2
stars, and the bottom
10%
receive
1
star.
Once we’ve created the Morningstar Rating for the
three-, five-, and
10
-year periods, we roll these
separate ratings into one overall rating for each fund.
If a fund has
10
years or more of performance history,
the overall rating is weighted like this:
50%
for the
10
-year rating,
30%
for the five-year, and
20%
for the
three-year. If a fund has fewer than
10
years of
history, the five-year rating counts as
60%
and the
three-year rating counts as
40%
of the overall rating.
For funds less than five years of age, the three-year
rating stands as the overall rating.
Figuring Out Why a Rating Changed
Because a fund’s returns are based on rolling three-,
five-, and
10
-year periods, the month rolling off the
back end of those time periods is just as likely to be
responsible for a rating change as the month that
just passed. A fund that had a brilliant year nine years
ago may see its star rating decline if the current year
is weaker than the year rolling off.
œ
What is Morningstar
FundInvestor
500
?
The Morningstar FundInvestor
500
features the industry’s
best and most notable funds.
Use the list to get new in-
vestment ideas and track the
funds you already own.
FundInvestor
subscribers have
access to one-page monthly
reports on all 500 funds on
mfi.morningstar.com. Just
type in the name or ticker of
the fund in the search box.
How the Star Rating Works
Changes to the 500
|
Russel Kinnel
