written by: Brian Nelson•edited by: Rebecca Scudder•updated: 7/30/2009
You’ve heard of Morningstar a million times. Everywhere you look someone is telling you how many stars their mutual fund has. What are these ratings anyway?
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Morningstar Mutual Fund Rating System
Morningstar was looking for a way to make ratings for mutual funds less complicated.It came up with the 5-star system in which mutual funds were rated from 1-star up to 5-stars.A five star fund was a top rated mutual fund and a one star fund was a bottom rated fund.
The idea was that an investor could use the star ratings as a starting point for their mutual fund research, theoretically reducing the number of investment choices by being able to quickly eliminate dog investments.But, the stars were never meant to be the ONLY research criteria investors looked at. Unfortunately, that is just what happened.
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Understanding Mutual Fund Morningstar Ratings
The first thing to understand about Morningstar mutual fund star ratings is that there isn’t just one for each mutual fund.In fact, there are several ratings based upon what timeframe you are looking at.Thus, a mutual fund can be a five star fund for the one year rating, but a three star fund for the three year rating, and maybe even a two star mutual fund for the 10 year rating.Guess which one the mutual fund uses in their advertising?
The second thing to understand about Morningstar’s star rating system is that the ratings stay with the mutual fund even if the fund manager leaves.If a mutual fund manager with good consistent performance retires, or leaves to start his own investing company, the mutual fund he leaves behind keeps the rating even though someone completely different will be running the mutual fund.
That means that a bad fund manager can be hidden for several years while the better performance of his predecessor artificially inflates the new managers rating.By quoting the 3, 5, or 10 year ratings, the now low performing fund still looks like a star.
To avoid these issues and make smart mutual fund investments, always look beyond just the Morningstar rating.Be sure to find out how long the manager has been running the fund.Compare the performance of a new manager to the old manager to see if the fund is just riding the old manager’s coattails.
Also, always look at the individual year performance and not just the standard 1, 3, 5, and 10 year averages.Averages have a way of covering up poor performance and hiding a fund’s actually volatility.