The Morningstar Rating for funds, aka the star rating, is a useful starting point for fund research. It is a straightforward "report card" based on funds' trailing risk-adjusted returns. Like any measure that relies on past performance, the star rating has limitations; but it's a useful starting point for research that points investors in the right direction.
The star rating is a quantitative measure that ranks funds each month based on their trailing 3-, 5-, and 10-year risk-adjusted returns versus their Morningstar Category peers. (Until late 2016, the star rating calculation also adjusted returns for the effects of sales commissions paid to own a fund.)
The star rating follows a bell-shaped distribution: The 10% of funds with the best rankings receive a 5-star rating; the next 22.5% get 4 stars; the 35% after that earn 3 stars; the next 22.5% receive 2 stars; and the bottom 10% of funds earn 1 star. With few exceptions, any fund that possesses a three-year track record is eligible to receive a star rating.
We launched the star rating in the U.S. in 1985, at a time it was common for investors to chase short-term performance and embrace gimmicky funds. Seen in that light, the star rating prefigured important investing advances, as the methodology incorporated factors like cost, risk, and investment style before they came into vogue. As these factors gained greater acceptance and the star rating achieved prominence, fund managers refocused on fees, extended their investment time horizons, and better accounted for risk in the portfolios they were assembling.
The star rating also ushered in other notable innovations, like forward-looking ratings, which intensified the focus on fees and brought new concepts, like misalignment of manager incentives, to the fore.
Background
We've long believed in the merit of the straightforward, transparent approach the star rating takes to ranking funds: It's an objective "report card" on funds' past performance. By the same token, we've frequently acknowledged the star rating's limitations, which are common to any measure that relies on past performance.
Since launching the star rating in 1985, we've augmented it with a host of other tools and measures and made enhancements to our methodology several times along the way.
We've encouraged users to consider combining the star rating with other data and measures to aid in fund selection. In this way, users could benefit from some of the star rating's more distinctly valuable features--that is, the way it emphasizes longer time frames, accounts for risk, and measures performance after fees and charges, considerations that don't normally figure into "leaders and laggards" tallies--while leveraging other forward-looking measures like the Morningstar Analyst Rating.
In that context, we've often described the star rating as a potential starting point for research.
