The Morningstar Rating: How to Use It

Many investors buy funds based on the Morningstar Rating, our quantitative rating for funds (we also offer qualitative research reports, and will soon launch a qualitative rating). Those odds make sense. The star rating reflects strong performance, and investors tend to flock to those funds.

Unfortunately, finding a top performer isn't always that easy. As we've pointed out in the past, a high Morningstar Rating isn't a guarantee that a fund will be a solid performer. A fund may very well have a 5-star rating because of its impressive historical record, but, as performance-chasers often find out the hard way, the past doesn't reliably predict future returns.

That's not to say that the Morningstar Rating doesn't serve as a valuable tool for investors, but it shouldn't be used in isolation. In this article, we'll walk you through what the star rating is, what it tells you, and what it doesn't. Finally, we'll discuss some other factors to consider, outside of a fund's star rating, when making decisions about which funds to buy and sell.

How the Morningstar Rating Works
The Morningstar Rating is a risk-adjusted, cost-adjusted comparison of fund performance within fund categories. The underlying methodology is robust and too detailed to go into in depth here, but suffice it to say that the rating accounts for periods of volatility--downward volatility in particular--and also adjusts for fund expenses, including sales charges. That means the more expensive the fund is, the harder it will be for the fund to earn a high star rating.

Every fund is rated versus its category peers over three discrete periods: three years, five years, and 10 years. Funds are rated on a curve, with the top 10% and bottom 10% of risk-adjusted performers in each category receiving one star and five stars, respectively. The next 22.5% at each end of the scale receive two stars and four stars, respectively, whilst the middle 35% receive three stars.

The Overall Morningstar Rating, the one most cited in the media, is a weighted average of the rating for all three periods. In keeping with the view that funds are long-term investment vehicles, the Overall Rating puts the most emphasis on longer time periods. For a fund with 10 years of history, we put 50% of the weight on the 10-year period, 30% on the five-year period, and 20% on the three-year period. For a fund with five years of history, we put 60% of the weight on the five-year period and 40% on the three -year period.

What the Morningstar Rating Tells You
With thousands of funds in existence, the star rating can serve as a reasonable way to narrow the universe down to a subset of funds with strong records of performance. Because the rating takes volatility into consideration, investors who focus on top-rated funds aren't ignoring the painful drops that have occurred, and they are also sticking with funds that have been able to justify their total expense ratios over time. Moreover, because the rating emphasises long-term performance, it helps investors avoid funds with alluring short-term performance but poor long-term records. That's an important screen: Even the worst of funds can have bouts of strong returns.

Comparing funds within their respective Morningstar categories is another strength of the star rating. All categories, from small-growth to large-value, fall out of market favour from time to time. By judging funds against their closest competitors, investors can focus on the top performers within a given category without worrying whether the rating is penalizing funds for sticking to an out-of-favour style. Investors can also be assured the fund isn't being rewarded for a style tailwind that would have helped any manager running money using that strategy.

What the Morningstar Rating Doesn't Tell You
A measure that takes long-term returns, risk, and cost into account is a good first step in a search for best-of-breed mutual funds. The key word, though, is first. While the star rating is a quick and easy way to get a feel for a fund's historical performance, it doesn't capture--nor was it designed to capture--all the factors that will contribute to a fund's future returns. True, early studies have found that higher-rated funds perform better than lower-rated funds, but that's far from a guarantee of outperformance.

The star rating doesn't take into account a fund's fundamentals--what makes it tick. Management turnover, strategy shifts, and rising expenses are a few of the most obvious changes that could mean that a fund's future won't reflect its past. We control for some of these in our Rating methodology, but investors always need to understand what drove past performance and whether or not those drivers remain in place.

Evaluating Funds: Seeing the Bigger Picture
To see the big picture, investors are best off combining the star rating with additional analysis. Start with management experience: How much of the fund's record can the current management claim? And even if the crew currently in place has racked up a strong record, was it simply the matter of getting one big bet right, or does the team have a record of consistently spot-on calls? Strategic changes matter, too: If, for instance, a management team earned a strong long-term record with a value bias, a red flag should go up if the team now focuses more on higher-priced, growing companies. Finally, investors should also evaluate whether expenses are climbing higher or trending down. We've found expenses to be one of the more reliable indicators of future performance, so funds with falling expense ratios are better positioned than their expensive rivals for a bright future.