If you are even remotely interested in investing or in the market, you would have been directed to Morningstar as a resource for making an informed decision. As a naive investor, it can be helpful to have a guiding strategy in the form of a trusted investment-research firm. It is therefore important to first understand what this resource actually entails.
What is Morningstar Rating?
Morningstar fund rating is a ranking system for publicly traded mutual funds and exchange-traded funds. The mechanism involves the use of quantitative research methods by the investment research firm Morningstar to assess the risk-adjusted performance of funds.
The funds under consideration are evaluated over a period of three or five or ten years in respect of the performance of similar funds that are grouped under the same category. This performance is assessed on the basis of variations in the monthly returns of the funds relative to similar ones. The ratings are then assigned between one and five, with five being the highest in order to help investors identify which funds to consider for their portfolio.
What time scales does the rating take into account?
A Morningstar Fund Rating is calculated over periods of three, five and ten years. This means that as a fund keeps getting older, it gets more than one rating. For example, a fund that has been operational for ten years will be given three different ratings: a two-year rating, a five rating and a ten-year rating. The overall rating of a fund will be a weighted average of these three. This means that the separate measures are taken, assigned weights and then averaged to chalk down the overall measure.
The weights are given proportionately: the ten-year rating accounts for 50% of the overall rating, the five-year rating accounts for 30% and the two-year rating accounts for 20% weight. A small but important note: funds with less than three years of existence/performance history are not rated.
Does the fund look at past or projected figures?
Morningstar Ratings are based on past performance, that is, the assessment takes into account historical returns. It is worth mentioning here that while past performance is not an absolute indication of future performance, it is a valid assessment of the likely performance.
What is the objective/purpose of Morningstar Ratings?
The purpose of these mutual fund ratings is to act as a reference metric to help investors compare individual funds, and see which fund managers have proved their mettle under tough market situations.
How are Morningstar Ratings done? Are they effective?
The Morningstar Fund Ratings have emerged as one of the most referred metrics when investors have to make decisions about their mutual fund investments. These ratings are purely quantitative, based on past performance, and lack any subjectivity.
Since there are reams of mutual fund schemes available, this metric is, first and foremost, an effective way to dice and slice the innumerable options into a manageable ranking. This ranking can help an investor identify the small coterie of funds that can serve their investment needs.
In this era of fickle attention spans and scanty time, such a ranking is great. And yet, it is just an assessment of the past performance, a parameter that doesn’t live in isolation from the rest of the factors operating in the marker. Reports[1] have shown that the analysis by Morningstar is indeed helpful.
So, sure, Morningstar ratings are indicative, but they aren’t the absolute or definitive truth.
Are all funds rated at Morningstar?
Not all funds get a rating at Morningstar. One filter, as mentioned before, is that they should be older than 3 years. Other funds that aren’t considered under the purview of Morningstar include funds that have insufficient details available or funds that don’t have similar funds; or funds whose operational strategy has changed substantially, making their past performance inconsequential on their future.
What is the rating scale?
It is a 5-star rating scale.
| Stars | Position in the respective Category |
| 5 stars | Top 10% |
| 4 stars | Next 22.5% |
| 3 stars | Middle 35% |
| 2 stars | Next 22.5% |
| 1 star | Bottom 10% |
Conclusion
Your fund manager may provide you with factsheets about the performance of your funds, like Future Generali mutual funds does, but Morningstar rating is a useful resource for investors and potential investors, in that it provides them with useful analysis, ratings and measuring sticks to better calibrate the odds of succeeding with their fund investments based on recent trends and longer-term history.
[1] Source: https://www.academyfinancial.org/resources/Documents/Proceedings/2015//C2_Bolster.pdf