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Course 206
Gauging Risk and Return Together, Part 2

Introduction

Our last session focused on two common measures of risk-adjusted performance: alpha and the Sharpe ratio. But as we pointed out, both of those figures need a context to be useful. Who can say whether an alpha of 0.7 is good? Or whether a Sharpe ratio of 1.3 is good?

That's where Morningstar's proprietary fund rating, often called the star rating, comes in. Unlike alpha and the Sharpe ratio, the Morningstar Rating for Funds puts data into context, making it more intuitive. You can find a fund's Morningstar Rating on its Morningstar fund report.

What Is the Star Rating?

Let's clear the air immediately: The star rating is a purely mathematical measure that shows how well a fund's past returns have compensated shareholders for the amount of risk it has taken on. Morningstar fund analysts don't assign star ratings and have no subjective input into the ratings. Morningstar doesn't subtract stars from funds we don't like or add stars when we do.

The Morningstar Rating is a measure of a fund's risk-adjusted return, relative to similar funds. Funds are rated from 1 to 5 stars, with the best performers receiving 5 stars and the worst performers receiving a single star.

Morningstar gauges a fund's risk by calculating a risk penalty for each fund based on "expected utility theory," a commonly used method of economic analysis. It assumes that investors are more concerned about a possible poor outcome than an unexpectedly good outcome, and those investors are willing to give up a small portion of an investment's expected return in exchange for greater certainty.

Consider a simple example—a fund expected to return 10% each year. Investors are likely to receive 10%, but past variations in the fund's return suggest there's a chance they might end up with anywhere from 5% to 15%. While receiving more than 10% would be a pleasant surprise, most investors are likely to worry more about receiving less than 10%. Hence, they'd probably be willing to settle for a slightly lower return—say 9%—if they could be reasonably certain they'd receive that amount. If a fund expected to return 10% each year, but variations in its past returns suggested a narrower 8% to 12% range, investors wouldn't want to forego as much of the expected return in exchange for increased certainty.

This concept is the basis for how Morningstar adjusts for risk. A "risk penalty" is subtracted from each fund's total return, based on the variation in its month-to-month return during the rating period, with an emphasis on downward variation. The greater the variation, the larger the penalty. If two funds have the exact same return, the one with more variation in its return is given the larger risk penalty. Funds are ranked within their categories according to their risk-adjusted returns (after accounting for all sales charges and expenses). The 10% of funds in each category with the highest risk-adjusted return receive 5 stars, the next 22.5% receive 4 stars, the middle 35% receive 3 stars, the next 22.5% receive 2 stars, and the bottom 10% receive 1 star.

For multi-share-class funds, each share class is rated separately and counted as a fraction of a fund within this scale, which may cause slight variations in the distribution percentages. This accounting prevents a single portfolio with multiple share classes in a smaller category from dominating any portion of the rating scale.

Funds are rated for up to three periods—the trailing three, five, and 10 years—and ratings are recalculated each month. Funds with less than three years of performance history are not rated. For funds with only three years of performance history, their three-year star ratings will be the same as their overall star ratings. For funds with five-year records, their five-year histories will count for 60% of their overall rating and their three-year rating will count for 40% of the overall rating. For funds with more than a decade of performance, the overall rating will be weighted as 50% for the 10-year rating, 30% for the five-year rating, and 20% for the three-year rating.

If a fund changes Morningstar categories during the evaluation period, its historical performance within the other category is given less weight in its star rating, based on the magnitude of the change. (For example, a change from a small-cap category to large-cap category is considered more significant than a change from mid-cap to large-cap.) Doing so ensures the fairest comparisons and minimizes any incentive for fund companies to change a fund's style in an attempt to receive a better rating by shifting to another Morningstar category.

</FONT>Caveats

Like all backward-looking measures, the star rating has limitations. It is critical to remember that the rating is not a forward-looking, forecasting tool. The rating won't predict short-term winners. The star rating is best used as an initial screen to identify funds worthy of further research—those that have performed well on a risk-adjusted basis relative to their peers.

The star rating is a strictly quantitative measure—a high rating doesn't imply the approval or endorsement of a fund by a Morningstar analyst. Additionally, if a management change occurs, the ratings stay with the fund, not with the portfolio manager. Therefore, a fund's rating might be based almost entirely on the success of a manager who is no longer with the fund.

Also, because funds are rated within their respective categories, it's important to note that not all 5-star funds are equal or even interchangeable. A 5-star sector fund, for example, might have the best risk-adjusted return within its specific category, but it's probably far riskier than a highly rated diversified fund.

Rather than buying funds based on their ratings, investors should first decide on an overall portfolio strategy and then seek the best funds for each portion of their portfolios. Use the star rating as a first screen.

Quiz 206
There is only one correct answer to each question.

1 Star ratings are:
a. Assigned by analysts.
b. Short-term predictive measures.
c. Mathematical measures of risk-adjusted performance.
2 Which statement is false?
a. Star ratings measure a fund's risk-adjusted performance against funds in the same category.
b. A fund must have at least three years of performance history to qualify for a star rating.
c. A fund automatically loses a star if its manager leaves.
3 Which fund probably earns a 5-star rating?
a. A fund with extraordinary returns and low risk.
b. A fund with very low returns and average risk.
c. A fund with average returns and average risk.
4 The Morningstar Rating is meant to identify funds that:
a. Will have the best short-term returns in the future.
b. Every investor should own.
c. Could be worthy of future research.
5 Morningstar will only rate a fund if:
a. It has at least three years of performance history.
b. It has at least 10 years of performance history.
c. The fund manager is nice to us.
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