The Morningstar Rating for Funds

Morningstar Analysts 01 July, 2007 | 0:00
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In 2001, Morningstar launched its Rating and Fund Categories methodologies in Asia to help streamline their fund research and selection process. In 2007, a few enhancements are made to Morningstar Pan-Europe/Asia Fund Rating and Categories methodologies. The Morningstar RatingTM ranks funds from one to five stars. As always, the Morningstar RatingTM is not an indicator of future performance, it can be used to gauge how a fund has performed relative to similar offerings.

Category-based Ratings
The Morningstar Rating calculation is based on fund category in order to distinguish managers with greater skills in managing certain types of portfolio. Effective July, 2007, Morningstar debut enhancements to further refine our rating system and categories. These improvements reinforce the key principles behind the rating system: To assess funds within their relevant peer group; evaluate funds over a long-term horizon; and adjust a fund? past performance according to both risk and costs. Morningstar Risk-Adjusted Return (MRAR) will continue to be the basis of the star-rating calculation.

For the updated list of Morningstar Pan-Europe/Asia categories, please click here.

Enhanced Risk Measure
We assign ratings to all member funds that have at least 36 continuous months of total return data, up to and including the evaluation month. When a category has less than 5 members, no star rating is assigned to the group.

The Morningstar RatingTM aims to assist investors in identifying managers whom add value to their funds, and funds with superior risk-adjusted, long-term performance. There is no subjective component to the rating and rating results are determined by how well a fund's risk-adjusted return compares to the risk-adjusted returns in the same category. Funds will be graded on a curve so that there will be as many five-star funds as one-star funds.

The Morningstar RatingTM takes risk into consideration by accounting for all the variations in a fund’s month-to-month performance, with stronger emphasis placed on the downward variations. Funds are ranked using Morningstar Risk-Adjusted Return (MRAR) and the metric is motivated by expected utility theory, according to which an investor ranks alternative portfolios using the mathematical expectation of a function (called the utility function) of the ending value of each portfolio. The calculation formula is much more complex, but it helps reduce the rating’s susceptibility to market drifts that lift or dent the ratings of funds investing in specific areas of the market. Essentially, the rating system is to reward consistent performance and penalizes risks in all cases.

Based on MRAR results, funds with the highest scores receive the most stars. Funds will still be compared within their respective categories. The star assignment remains to have the top 10% of funds in a category receiving five stars, the next 22.5% having four stars and so on (see figure below for star distribution).





We also treat funds with multiple share classes differently. Despite sharing the same portfolio, the different share classes have their own expense structures that lead to different return for each class. To prevent a single portfolio from dominating any portion of the rating scale, each share class will be rated separately but will only be counted as a fraction of the fund in the rating distribution. In other words, a single portfolio now counts only once, regardless of the total number of share classes.

Each fund is rated over three-year, five-year and ten-year period; given that they have at least 36 continuous months of total return data. Then, an overall star rating for each fund is based on the weighted average of the number of stars assigned to it in the three-year, five-year and ten-year rating periods. If the fund in question has been in its current category over its entire evaluation period, the weights are:

Months of Total Returns

Overall (Weighted) Morningstar Rating

24-35

Not applicable

36-59

100% three-year rating

60 -119

60% five-year rating

40% three-year rating

120 or more

50% ten-year rating

30% five-year rating

20% three-year rating

While the long-term overall star-rating formula seems to give the most weight to the 10-year period, the most recent three-year period actually has the greatest impact because it is included in all three rating periods. Investors can thus compare a fund's performance with its peers for different time periods with greater convenience.

How to use the Morningstar Rating
The Morningstar RatingTM is based solely on a mathematical measure of past, risk-adjusted performance; there is no subjective component in the rating. Having a good rating does not mean that a fund is good for all investors, nor does it suggest that the fund will continue to perform as it has in the past. The Morningstar RatingTM offers investors an initial screening tool to simplify the fund research process and should not be considered as buy or sell recommendations.

Investors should keep the following points in mind before they purchase a fund:

If a management change occurs, the Morningstar Rating stays with the fund, not the portfolio manager(s). This implies a fund's star rating might be based almost entirely on the success of a manager who is no longer with the fund.

The Morningstar Rating is a relative measure within different groups that have similar investment objectives. Within each peer group, 10% of the funds with at least three years of history earn five stars. This is true even when the peer group as a whole performs miserably in absolute terms over a three-year period.

Morningstar Rating change. A falling rating might not be the result of a negative change in the fund's performance, but rather improved performance of other funds in its peer group. The important thing to keep in mind is a falling star should not be interpreted as an automatic sell signal.
For further details of our new rating methodology, please click here.

 

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