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The Secrets of the Star Rating

We look under the hood of the star rating and follow its impact of 3 funds from June 2002- May 2006.

Russel Kinnel, 07/25/2006

In the past, I've described how the Morningstar Rating for funds has shown itself to be a decent predictor of performance. On average, 5-star funds outperform 4-star funds, which on average beat those with 3 stars, and so on. Because the star rating is based on performance within a category, it captures relative advantages, such as low costs and manager skill, that give a fund an improved chance of success in the future. In fact, low-cost 4- and 5-star funds seem to do particularly well.

Because the Morningstar Rating can be helpful in selecting and monitoring funds, advisors are increasingly interested in how it is calculated. This month I'll discuss the calculation and track three funds' past ratings to illustrate how star ratings can shift over time.

How It Works

The Morningstar Rating for funds is a purely quantitative 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. 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 consistent performance. We know that investors do much better using consistent funds than those that swing wildly from one extreme to another, particularly in cases of extreme losses. We take a fund's returns and risk scores and then see where they land on the utility function curve. Essentially, this measures how well the investor is compensated for the riskiness of the fund.

Next, we rank all of the portfolios 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 star rating.

Following the Ratings of Three Funds

Let's track the progress of three large-growth funds from June 2002-when the current star rating methodology was adopted-through May 2006. If you see a star rating change, it could be because the fund just had a great or bad month, or it could be that an extreme month has just rolled out of one of the trailing time periods. Consider that the three-year return figure is now entirely clear of the bear market of 2000-2002, while the five-year return includes some of the bear market but sheds another month of it each month. This is why some aggressive-growth and technology funds have seen their star ratings rise recently-particularly if they don't have a 10-year record.

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