The Morningstar Rating for funds, often called the “star rating,” was launched in Asia in 2001 to provide investors a quick and easy way to identify funds that are worthy of further research. The Morningstar Rating rates funds from one to five stars, with five-star funds being the best performers within their relevant peer groups. Investors should note that the Morningstar Rating gauges how a fund has performed relative to similar offerings in the past and is not an indicator of future performance.
Category-based Ratings
Morningstar assigns the Morningstar Rating based on comparisons of funds within a specific Morningstar Category. This is guided by two general principles: Firstly, the relative star ratings of funds with similar investment strategies should be affected more by manager skill than by market circumstances or events that lie beyond the fund managers’ control. Secondly, peer groups should reflect the investment opportunities for investors; that is, funds within a particular rating group should be valid substitutes for one another in the construction of a diversified portfolio.
For the latest Morningstar Category Definitions for European/Asian and South African funds, please click here.
Morningstar Risk-Adjusted Return (MRAR)
The Morningstar Rating aims to assist investors in identifying funds with superior risk-adjusted, long-term performance. It takes risk into consideration by accounting for all the variations in a fund’s month-to-month performance, with stronger emphasis placed on downward variations. In calculating the rating, funds are ranked using Morningstar Risk-Adjusted Return (MRAR), which is based on expected utility theory. This framework recognizes that investors are risk-averse and willing to give up some portion of expected return in exchange for greater certainty of return. Essentially, the Morningstar Rating rewards consistent performance and penalizes risks.
MRAR is adjusted for sales loads, the risk-free rate, and risk.
Three-, Five-, and 10-Year Ratings
Funds must have at least 36 continuous months of total returns in order to receive a Morningstar Rating. When a category has less than 5 funds, no star rating is assigned to the category. Morningstar ranks all eligible funds in a category using Morningstar Risk-Adjusted Return (MRAR), and the funds with the highest scores receive the most stars.
Morningstar evaluates each share class of a portfolio separately, because each share class has different loads, fees and total return time periods available. However, to avoid multi-share funds from taking up a disproportionate amount of space in any rating level, fractional weights are assigned to funds that are merely different share classes of the same underlying portfolio. In other words, a fund with multiple share classes is only counted once within the rating distribution scale.
The distribution of funds across the rating levels forms an approximate bell curve. Top 10% of funds with the highest MRAR in a category receive five stars; the next 22.5% receive four stars, and so on. See figure below for star distribution:
Each fund is rated over three-year, five-year and ten-year periods using the same procedure. Then, an overall star rating for each fund is calculated 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:
While the 10-year 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.
How to use the Morningstar Rating
The Morningstar Rating is based solely on a mathematical measure of past, risk-adjusted performance; there is no subjective component in the rating. A high rating does not necessarily mean that a fund is suitable for all investors, nor does it suggest that the fund will continue to perform well in the future. The Morningstar Rating offers investors an initial screening tool to simplify the fund research process and should not be considered as buy or sell recommendations. For subjective and forward-looking fund ratings, please refer to our Morningstar Analyst Ratings.
Investors should keep the following points in mind when interpreting the Morningstar Rating:
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 on the success of a manager who is no longer with the fund.
The Morningstar Rating is a relative measure within groups that have similar investment objectives. Within each peer group, 10% of the funds with at least three years of history earn five stars in each rating period (three-year, five-year and ten-year).. This is true even when the peer group as a whole performs poorly in absolute terms.
Change in Morningstar Rating. There are many reasons for a change in rating other than weak peer-relative performance. The important thing to keep in mind is that a drop in star rating should not be interpreted as an automatic sell signal.
For the full Morningstar Rating methodology, please click here.
