Use star ratings to invest wisely

Key Takeaways

• The Morningstar Rating is a quantitative measure of a fund's risk-adjusted return relative to similar funds, assigning a one-to-five-star ranking to each fund. 

• The Morningstar Rating could help you quickly assess a fund's track record, compare similar funds, and may be able to build a better investment portfolio.

• The Morningstar Rating is not infallible, and please don't make investment decisions entirely based on it.

When checking in hotels, there are five-star hotels that offer first-class service.

When screening funds, a star ranking may also help you: the Morningstar Rating.

You may have seen the Morningstar Rating for funds on a page like this.

Understanding the Morningstar Rating

Twinkle, twinkle, little star. What do you need to know about the Morningstar Rating?

Morningstar is one of the leading global providers of independent investment research. The Morningstar Rating for funds, also known as the star ratings, is a quantitative of a fund's risk-adjusted return relative to similar funds. 

It could help you quickly and easily assess a fund's track record and build a better portfolio. Like using the North Star to sail the seas, the Morningstar Rating may point the directions for investors. 

The Morningstar Rating assigns a one-to-five-star ranking to each fund: the top 10% of funds receive five stars, the next 22.5% get four stars, the middle 35% earn three stars, and the next 22.5% receive two stars, and the bottom 10% get one star.

Investments are rated for up to three periods: three, five, and ten years.

An overall rating is based on the three periods' ratings, updated at the end of each month. Investments with less than three years of history are not rated.

Count the stars correctly may help you invest wisely

1. Morningstar Category is the basis of star rating

It is difficult to tell which is better, an apple or a banana. The same goes for comparing a three-star equity fund with a five-star bond fund.

However, when comparing funds with similar competitors, you could focus on the top performers within a specific category and consider replacing the underperformers in portfolios.

2. Higher is not always better

The Morningstar Rating is a good starting point to help narrow the selections. Still, it is just a measurement of historical performance, which doesn't necessarily ensure future returns. There is no guarantee that high-rating funds will outperform similar funds in the future, and high-rating funds may not fit your risk tolerance.

3. Investment decisions shouldn't be made solely on the rating adjustment

Taking a rating drop as a signal to sell funds is not recommended. The drop in Morningstar Rating does not necessarily indicate the fund's poor performance, which may occur due to the better performance of other funds in the same category.

You need to assess future market conditions and your portfolio preferences carefully.

4. The star rating isn't the only available fund rating 

Among all fund ratings, Morningstar Star Rating for funds is the most widely referenced form of Morningstar Ratings. Other ratings, including Analyst Ratings, Quantitative Ratings, and Sustainability Ratings, are also available.

Source: Morningstar

Moreover, financial service firms like Thomson Reuters Lipper, Zacks Investment Research, Standard and Poor's, and The Street also provide ratings.

Besides the Morningstar Rating, we will introduce more indicators to help you thoroughly assess the fund's performance. See you next time!