How to read Morningstar mutual fund ratings

Open full sized image

Powerful tools to help you choose from the universe of funds.

© Alexandr/stock.adobe.com, © CaptureAndCompose/stock.adobe.com; Photo illustration Encyclopædia Britannica, Inc

If you’re researching mutual funds for your 401(k) plan or browsing investment options through your brokerage account, you’ve likely come across star ratings or a “style box.”

Stars and style have nothing to do with movies or fashion, but everything to do with empowering you to become a better investor. Morningstar is known for its mutual fund ratings, which can help you make sense of thousands of investment options.

Learning how to read Morningstar ratings and how to interpret its fund style classifications can help you make more informed decisions. Although companies like Lipper, CFRA Research, and Zacks also publish fund ratings, Morningstar remains the system most widely encountered by everyday investors.

When you look up a mutual fund, one of the first details you may come across is its Morningstar star rating, typically displayed after the fund’s name.

Morningstar uses a scale of one to five stars to measure a fund’s past performance compared to similar funds, after adjusting for the level of risk involved in generating those returns. Five stars mean the fund has exceptional historical performance, one star signals historical underperformance, and two, three, and four fall somewhere in between.

Comparing funds in the same category rather than judging funds throughout the entire fund universe keeps the comparisons straightforward. For example, a five-star, large-cap U.S. growth fund is compared only with other large-cap U.S. growth funds, not against, say, bond funds or international small-cap value funds.

Morningstar’s formula also looks at risk-adjusted returns over three-, five-, and 10-year periods to calculate an overall rating. Risk-adjusted returns account for both the fund’s returns and the volatility it experienced along the way. This approach explains why two similar funds with the same returns can behave very differently; one may fluctuate sharply, while the other remains stable.

Morningstar assigns its star ratings based on how each fund ranks within its category:

Morningstar updates these ratings monthly, giving investors a fresh look based on the most recent performance data. Star ratings reflect how a fund performed in past market cycles; they don’t predict how it will do in future market conditions.

Also, when you look at a fund’s return over time, the number you see—and what you’ll receive—is the net return after fees. The category peer average return is also reported after fees, so you’re comparing what investors actually earned. Within the industry, the return after fees are deducted is called net of fees. Morningstar also shows each fund’s category benchmark index, which excludes fees. Often, you’ll see that it’s harder for funds to beat a benchmark because fees eat into performance.

Because Morningstar’s star ratings measure past performance, the company also developed another metric: medalist ratings, a system that gauges a fund’s potential to outperform its benchmark or peer group. The medal ratings appear alongside the stars.

For funds covered by a Morningstar analyst, the medal rating is based on an analyst’s in-depth, qualitative evaluation. Analysts interview portfolio managers, assess the fund company itself, and study the fund’s management, strategy, and long-term record.

Funds not covered by an analyst are evaluated by Morningstar’s machine-learning model, which uses similar criteria to estimate how those funds might perform relative to their peers.

Morningstar assigns five medalist ratings: gold, silver, bronze, neutral, and negative. Funds that earn gold, silver, or bronze are predicted to outperform their benchmark over time, while those rated neutral or negative are expected to match or lag it.

Only about 23% of the nearly 200,000 funds analyzed by Morningstar receive one of the top three medals, whether evaluated by human analysts or the company’s computer model.

Morningstar’s medalist ratings are built on three pillars the company considers key to a fund’s long-term success: people, process, and parent.

In investing, style describes how a fund’s portfolio manager selects securities. Funds generally fall into three categories: value, growth, and blend, which combines elements of both.

Next to the star and medalist ratings, the Morningstar style box is the best-known feature of the research firm’s fund analysis. There’s a version for mutual funds and another for exchange-traded funds (ETFs), with separate style boxes for equity and fixed-income investments.

Open full sized image

Figure 1: FUND CHARACTERISTICS. The Morningstar style box classifies mutual funds and ETFs by investment style and company size, helping investors compare how a fund’s holdings tilt toward value, growth, or a blend of the two.

Source: Morningstar, Inc.

A style box can help you understand what’s in the funds you’ve picked for your 401(k) plan or brokerage account. It’s an easy way to spot whether your portfolio is diversified or if your funds overlap in both investment style and company size. Knowing how to read the style box gives you an objective understanding of what’s in the fund, rather than relying on what the portfolio manager or the fund issuer says.

The equities style box features three categories: map, weight, and historical. Each offers a different perspective on the fund. The left side of the box represents market capitalization: small-, mid-, and large-cap companies. The top represents style: value, blend, or growth.

Open full sized image

Figure 2: FUND CONCENTRATION. The ownership zone shows where a fund’s holdings fall within the value/growth and large- to small-cap grid, illustrating how concentrated or spread out its investments are.

Source: Morningstar, Inc.

The style box helps investors understand how the individual portfolio holdings reflect the fund as a whole. For example, if a fund’s top three holdings each have 10% in big technology names, you’ll understand why the style box shows the fund as a large-cap growth fund.

The fixed-income style box has the same nine squares, but looks different from the equities box. There is no map, and the two categories are current and historical. It’s harder to assess a style for fixed income, because there’s not the same easily accessible information about the underlying holdings, and there are many more bonds than stocks. For fixed income, Morningstar uses the style box to give you a sense of quality and duration. Duration describes how likely it is that a bond or bond fund’s price might be affected by changes in interest rates.

The left of the style box shows the measure of the quality of the credit it holds: low, middle, and high. The top measures duration: short, medium, and long. A 30-year U.S. Treasury bond fund is likely to be in the upper right side of the style box, while a short-term, high-yield bond fund will likely land in the lower left side of the style box.

The historical view shows how often a bond fund’s manager has adjusted its holdings. For active managers, the fund’s style typically evolves as they respond to changing market conditions.

Smart investors use fund ratings in combination, rather than focusing on a single tool. The star ratings give a quick understanding of past performance; the medals offer an expert opinion on a fund’s future outlook; and the style box helps you understand a fund’s holdings and how it might fit into your portfolio. Mutual fund ratings, whether from Morningstar or other ratings companies, are just one piece of research for you to consider as you build an investment portfolio. Other factors, such as your risk tolerance, goals, and investment time horizon, matter just as much as economic conditions.

Specific companies and funds are mentioned in this article for educational purposes only and not as an endorsement.

Special thanks to Laura Lallos, managing editor at Morningstar.com, for her assistance with this article.