Getting the Most Out of Star Ratings and Analyst Picks

No matter what the analyst's specialty, however, one type of question seems to crop up more than any other: "If [name your fund] is so great, why does it only have 3-star rating from Morningstar?" I also tend to see a lot of variations on a related question: "Fund X has a 5-star rating from Morningstar, so why isn't it an Analyst Pick?"

Fund star ratings and Analyst Picks can be great additions to your research process, but it's essential that you know how we come up with them and how best to use them (and perhaps just as important, how not to use them). In this week's column, I'll discuss the basics of getting the most out of both sets of tools.

The Morningstar Rating for Funds
Morningstar's fund star rating is designed to give investors a quick snapshot of how a mutual fund has balanced risk and return in the past. We calculate a fund's star rating relative to other offerings that operate within that same category. We arrive at a large-cap value fund's star rating by evaluating how it has performed relative to other large-cap value funds, for example, and we compare short-term bond funds with other short-term bond funds. (Click here to read about the nitty gritty of our star-rating calculation.)

The fund star rating is strictly quantitative--analysts can't add stars to funds they like or yank them from those we don't. Because the star rating captures only a fund's past risk/reward profile, there will definitely be occasions when a fund with a low star rating has terrific future prospects, and vice versa.

How to Use It
With literally thousands of options, the fund universe can be a little bit overwhelming. That's where the star rating comes in: If you know you want a given type of fund, you can use the star rating to winnow that group down to a more manageable list of offerings that deserves further research. For example, say you want to buy a large-cap growth fund for an IRA. You can then turn to Morningstar's Basic Screener or  Premium Fund Screener to identify no-load, large-cap growth funds with manager tenures of five years or more, star ratings of 4 or better (indicating that their managers have done a decent job of balancing risk and return), expense ratios below the category average, and minimum initial purchases of $5,000 or less (the IRA contribution limit for 2009). In so doing, you can reduce the large-growth universe from over 500 funds to the 40 or so that fit your criteria and merit further research. True, you might miss out on that 1-star fund with bright prospects, but that's a small price to pay for greatly streamlining the number of funds you have to research further.

You can also use the star rating to help monitor your funds' performance. If your one-time 5-star fund is now sporting a single star, you should research what has driven the downturn. It's possible that the manager's style is simply out of favor and will eventually rebound. But a dramatic shift in a fund's star rating could indicate that there's something more substantive going on--maybe the fund is taking bigger risks than it once did, or perhaps its management team has changed.

How Not to Use It
Although the star rating can be a handy tool for monitoring your funds' performance, you shouldn't construe it as a buy and sell signal. Because we recalculate funds' star ratings every month, funds frequently gain or lose a star, and that action can best be described as "noise" that you should tune out. Moreover, a fund isn't automatically worth buying just because it earns a 5-star rating. There are 5-star funds in every category, so job one is determining which categories make sense for you in the first place. (A 5-star large-value fund might make sense for a broad swath of investors, but a 5-star precious-metals fund might not.) In addition, a fund's rating may not reflect underlying changes that make it more or less attractive--a manager or strategy change, for example. Finally, remember that the star rating is just a starting point for your research--not the be-all end-all for determining its future prospects. Although we'd stand by the assertion that 5-star funds are a generally better lot than 1-star offerings, you'll need to assess a number of other factors--notably, its strategy, costs, and management--to determine whether a given fund makes sense for you.

In contrast to our star ratings, which are strictly quantitative, our Analyst Picks are qualitative all the way. For each category, we assign an analyst to serve as the Analyst Picks guru, meaning that he or she is responsible for knowing the funds in that group inside and out and for staying abreast of the best and brightest within that category. (That same analyst is also responsible for alerting Morningstar.com's Premium members to any dogs within that group--so-called Analyst Pans.) The analyst must defend his or her recommendations for picks in the category to a four-member committee consisting of Russ Kinnel, director of fund research; Karen Dolan, director of fund analysis; senior analyst Mike Breen; and senior analyst Bridget Hughes. We vet the analyst's recommendations and submit suggestions of our own, eventually deciding on the final choices with the analyst..

How to Use Them
Whereas the star rating can lend a helping hand to investors who like to do their own research, our Analyst Picks list does the work for you. If you're looking at our Analyst Picks list for ideas, you can rest assured we've put all of the funds through their paces and believe that they have a strong shot at outperforming their rivals. (Our Analyst Pick criteria are so stringent that if we can't find any worthy funds within a given category, we'll go without; that's currently the case with the Japan-stock category, for example.) Our Analyst Picks list is also an ideal way to surface off-the-beaten path funds whose strong future prospects aren't reflected in their past records.

How Not to Use Them
As with the star rating, it's a mistake to view the Analyst Picks as a "must-own" list. While all of the funds on the list are tops within their categories, you may simply not need a fund within a given group. Also, think twice before supplanting a fund you own with one on our Analyst Picks list. It may well make sense to, but you should take tax and transaction costs into account before swapping out of a perfectly serviceable fund. By the same token, you shouldn't overreact if and when we take one of your holdings off our Analyst Picks list. We may be concerned about factors such as unchecked asset growth, for example. Although we may no longer believe a fund to be in the top tier of its peers, we'd might still recommend that current shareholders hang on to it. Consulting our Fund Analyst Reports can help you discern the situation and arrive at a good decision in such cases.