How Morningstar Rates and Ranks Mutual Funds

Morningstar, Inc. (NASDAQ: MORN) first introduced its rating system in 1985. The simple, easy-to-understand Morningstar platform quickly became a favorite of analysts, advisors and individual investors in the mutual fund world. Today, Morningstar is one of the most influential and prominent investment resources in the world, and it's a company that every interested person should take time to understand better.

Morningstar ranks mutual funds on a scale of one to five stars. These rankings are based on how the fund has performed – with adjustments for risks and costs – compared to funds in the same category. Each fund receives separate ratings for three-, five- and 10-year periods, which it combines into an overall rating.

The company claims that its mutual fund rankings are "objective, based entirely on a mathematical evaluation of past performance." While this is superficially true – all Morningstar rankings are math-based – it undersells how sensitive the ranking process is to two subjective factors: the weighting of the mathematical formula and the classification of a fund into a particular category.

Morningstar is best known for its star rating system, which assigns a one- to five-star ranking to each fund based on past performance relative to peer funds. Star ratings are graded on a curve; the top 10% of funds receive five stars, the next 22.5% receive four stars, the middle 35% receive three stars, the next 22.5% receive two stars and the bottom 10% get one star.

Morningstar doesn't offer an abstract rating for any fund; everything is relative and risk-adjusted. All funds are compared to their peers, and all returns are measured against the level of risk that portfolio managers had to assume in order to generate those returns.

Even risk and return ratings are made on a relative scale. The top 10% of funds with the lowest measured risk receive a Low Risk designation, the next 22.5% are Below Average and so on. Similarly, the top 10% highest returning funds receive a Highest Morningstar Return designation.

Morningstar organizes all equity research by market sector, allowing investors and analysts to compare equities with similar focuses. Some of Morningstar's equity sectors include cyclicals, basic materials, financial services, defensive, utilities, communication services, energy and technology.

In October 2010, Morningstar reworked its sector classification system, suggesting the new system was "more logical" and made it "easier to understand the decisions being made by portfolio managers." All stocks, funds and portfolios were split into three broad sectors: Cyclical, Defensive and Sensitive. Each such supersector contains three or four subgroups.

Within each subgroup, there are multiple industries. Each stock belongs to one of nearly 150 industries based on how Morningstar best identifies the underlying business model for the company. According to Morningstar, these equities are classified by a review of "annual reports, Form 10-Ks and Morningstar Equity Analyst input."

Each Morningstar fund can be quickly compared for exposure among the three supersectors, but a more thorough review is possible at the subgroup level.

Morningstar is steeped in modern portfolio theory (MPT), the investment philosophy centered around minimizing risks and maximizing expected returns by strategically diversifying assets. Morningstar's primary volatility measurements come straight out of MPT: standard deviation, mean and the Sharpe ratio.

Standard deviation is a basic statistical concept that determines how wide a fund's range of performance has been. A fund with less consistent returns over time – the numbers are more spread out – has a higher standard deviation. Calculate the standard deviation by taking the square root of the fund return variance, which is just the squared differences from the mean return. This is a reasonable and uncontroversial indicator of volatility.

The mean is just the average return of the fund. Morningstar calculates the mean based on an annualized average monthly return; if a fund gained 80% over the course of a year, its average annualized monthly return was 6.67% (80% divided by 12 months). The primary function of the mean is to serve as a base unit for the standard deviation.

The last of Morningstar's MPT volatility metrics is the Sharpe ratio, which determines how much extra return an investor receives for a given amount of extra assumed risk. Nobel laureate William F. Sharpe created the concept behind the Sharpe ratio in 1966, and it has been a favorite in the finance industry since. Calculate an investment's Sharpe ratio with the following formula:

Sharpe(investment) = (average return - risk free rate of return) / standard deviation of investment

Through the Sharpe ratio, Morningstar can compare the performance of one portfolio with another on a risk-adjusted basis.

The bear market decile rank is a non-MPT volatility and risk measurement in the Morningstar toolbox. Essentially, Morningstar compares every equity fund against the S&P 500 Index and every bond or fixed-income fund against the Lehman Brothers Aggregate Index. All equity funds and all bond funds are measured against each other and assigned decile rankings according to their performances during bear markets. It's a more sophisticated way to look at downside capture.

The standard Morningstar star rating is backwards-looking; it tells an investor which funds have performed best over a three-, five- or 10-year period. One common misconception is that Morningstar awards higher star ratings to funds it expects to perform better in the future, which isn't the case. There are no predictive or prescriptive elements in the star rating system.

Morningstar does have a forward-looking metric: the analyst rating for funds. The analyst rating is a summary of Morningstar's "conviction in the fund's ability to outperform its peer group and/or relevant benchmark on a risk-adjusted basis."

Analyst ratings are graded on a five-tier system, with three positive ratings of Gold, Silver and Bronze, plus a Neutral rating and a Negative rating. Morningstar determines analyst ratings based on how a fund scores across five pillars: process, performance, people, parent and price. Gold funds are the best, and are those in which Morningstar analysts have the highest confidence. Silver funds have advantages across all of the five pillars. Bronze funds show "notable advantages across several," though not all, pillars. Neutral funds don't receive analyst confidence for overperformance or underperformance. Negative funds show flaws that analysts believe will hamper future performance.