How stars are awarded and how to use them

How stars are awarded and how to use them

Over the years, Morningstar has become synonymous with its fund ratings (popularly referred to as “star ratings").

To understand the effective use of star ratings, let’s discuss what Morningstar ratings are all about. Star ratings make a great starting point for the investment exercise. Investors typically have a large number of funds to choose from. Star ratings can act as a filter for arriving at a pool of funds that have made the grade on the risk-adjusted return front. For example, if an investor wishes to invest in a large-cap fund, he could decide to pick only funds that have a track record of at least three years. Subsequently, the next filter could be funds that have a star rating of at least four stars or more.

The Morningstar risk-adjusted return (MRAR) forms the basis for computing star ratings. The MRAR is calculated based on the expected utility theory. The latter recognizes that investors are risk-averse and willing to give up some portion of an expected return in exchange for greater certainty of return. In other words, investors are more concerned about a possible poor outcome than an unexpectedly good outcome. Hence, Morningstar gives more weight to downside variation while calculating the MRAR.

The ratings take into account all variations in a fund’s monthly performance, with more emphasis on downward variations. Funds must have at least 36 months of track record in order to receive a Morningstar rating.

The Morningstar rating is within a given category. Each fund is evaluated against comparable peers for the rating purpose. Hence, the risk-adjusted performance of a large-cap fund (which belongs to the Morningstar large-cap category) is compared with that of other large-cap funds. This follows from the principle that any fund should be seen compared with its peers, rather as a “stand-alone" investment. Hence, it is important that funds within a rating group be substitutes for each other while constructing the portfolio. An important point to note here is that funds are categorized on the basis of the actual investment style and may not necessarily be the same as mentioned in the fund offer document. Morningstar analysts closely monitor the fund portfolios and classify the fund in the best-fit category, thus making sure that the investors are comparing funds having similar risk profiles.

The Morningstar rating is calculated every month for the three-, five-, and 10-year periods. Within each rating period, the top 10% funds receive a five-star rating, the next 22.5% earn a four-star rating, the next 35% get three stars, the next 22.5% receive two stars, and the bottom 10% get one star.

Star ratings are recalculated every month and may change for a variety of reasons, including change in return rating and risk ratings. In categories such as fixed income funds, where the range of returns is small, even a minor change in returns can result in a change in rating. A change in the investment style may also bring in a change in rating as the peer group may change. Morningstar analysts review the categorizations every quarter and make changes, wherever necessary.

Morningstar ratings can be a helpful tool in monitoring a fund’s performance. Say, a fund that enjoyed a five-star rating at the time of investment has been reduced to a three-star rating. In such a case, there is a need to investigate reasons for the same. It may reflect underlying changes that make the fund less attractive, say a manager or strategy change. If it’s simply a case of the investment style being out of favour, there may not be any cause for concern; conversely, if the same is on account of a change in the fund management team, maybe the fund’s presence in the portfolio needs to be questioned.

Another important factor which needs to be kept in mind is the suitability of a fund for the investor.

For instance, suppose an aggressively-managed sector fund bags a five-star rating in its category. Would that make the fund apt for a risk-averse investor? Not at all! But perhaps a five-star fund from the conservative asset allocation category could make a fit. In other words, investors need to understand all five-star funds are not alike.

In conclusion, star ratings can undeniably play an important role in the investment process. However, the key lies in accurately understanding them and then putting them to judicious use while constructing your portfolio.

Aditya Agarwal is managing director, Morningstar India.