(PUB) Morningstar FundInvestor

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How the Star Rating Works Changes to the 500 | Russel Kinnel

We look at a fund’s Morningstar Return and Morningstar Risk ratings to see where they land on the utility function curve. Essentially, this measures how well the investor is compensated for the riski- ness of the fund. Next, we rank all of the funds in a category from best risk-adjusted return to worst. The top 10% receive 5 stars, the next 22 . 5% receive 4 stars, the next 33% receive 3 stars, the next 22 . 5% receive 2 stars, and the bottom 10% receive 1 star. Once we’ve created the Morningstar Rating for the three-, five-, and 10 -year periods, we roll these separate ratings into one overall rating for each fund. If a fund has 10 years or more of performance history, the overall rating is weighted like this: 50% for the 10 -year rating, 30% for the five-year, and 20% for the three-year. If a fund has fewer than 10 years of history, the five-year rating counts as 60% and the three-year rating counts as 40% of the overall rating. For funds less than five years of age, the three-year rating stands as the overall rating. Figuring Out Why a Rating Changed Because a fund’s returns are based on rolling three-, five-, and 10 -year periods, the month rolling off the back end of those time periods is just as likely to be responsible for a rating change as the month that just passed. A fund that had a brilliant year nine years ago may see its star rating decline if the current year is weaker than the year rolling off. œ

Each month we provide Morningstar Ratings on funds in the Morningstar 500 . If a fund’s star rating has changed, we add a little down arrow or up arrow to tell you the direction of the change.

What is Morningstar FundInvestor 500 ? The Morningstar FundInvestor 500 features the industry’s best and most notable funds. Use the list to get new in- vestment ideas and track the funds you already own. FundInvestor subscribers have access to one-page monthly reports on all 500 funds on mfi.morningstar.com. Just type in the name or ticker of the fund in the search box.

I often get questions about why a rating has changed, so I’ll provide a rundown here.

The Morningstar Rating for funds is a purely quantita- tive measure of risk-adjusted (and load-adjusted) performance. It reflects a fund’s performance over trailing periods of three, five, and 10 years relative to its peer group. (Peer groups are categories like foreign large-blend or high-yield bond.) Although some people have the impression that star ratings reflect analyst opinions, our fund star rating is a purely objective reflection of past performance, updated once a month. To produce the star ratings each month, we calculate every fund’s risk-adjusted return for each applicable time period. This is done by applying a “risk penalty” to each fund’s returns based on expected utility theory, a commonly used method of economic analysis. (The theory assumes that investors are willing to sacrifice a little return in exchange for greater certainty.) This creates a curve measuring incremental changes in risk and return. Variation in monthly performance in either direction is penalized, but downside volatility receives a greater penalty. By design, this risk-adjusted return rewards consis- tent performance. We know that investors do much better using consistent funds than those that swing wildly from one extreme to the other, particularly in cases of extreme losses.