Ratings

Mutual funds are rated by Morningstar, a major provider of information about mutual funds. Morningstar uses a five-star rating system, with five stars the highest rating and one star the lowest rating. Many mutual fund companies run ads to tout any funds they manage that achieve high ratings, particularly five stars. The "star" system has become well known among investors.

Morningstar ratings are widely used by investors, who often search for funds with at least four stars, and preferably five. They feel that such a rating is a likely predictor of future success. However, it is important to note that this rating system is measuring historical risk-adjusted performance for funds that have at least a three-year history. The ratings take into account both a fund's risk relative to its category as a whole, and its returns, taking out the sales charge on a monthly basis.

When both the risk and return measures are put together, a rating can be determined for all funds in a set. The top 10 percent receive five stars, the next 22.5 percent receive four stars, and the middle 35 percent receive three stars, as shown in Figure 3-3. ^[7]

^[7] I constructed Figure 3-3 from commonly known information about the Morningstar rating system.

Figure 3-3. Morningstar's Rating System for Mutual Funds Based on the Number of Stars.

In effect, the Morningstar ratings show you how a fund has performed in the past. Always remember this when looking at glowing advertisements from mutual funds about the strong performance of their funds. Morningstar ratings evaluate the past, they do not predict the future.

The rating may be for a three-year period, a five-year period, or a 10-year period. Such information is clearly valuable , but it certainly cannot assure outstanding performance in the future. It tells you how a particular fund did perform, not how it will perform. There are examples of funds that were rated with five stars at some point in time and less than one year later had fallen to a one-star rating.