What is a Morningstar Rating?

When determining the best mutual fund or ETF to purchase among hundreds of choices, investors often use numerous metrics, such as past performance, risk measures, fees and manager tenure. One data point that is often used for comparison is the Morningstar rating.

Morningstar is one of the most well-known rating systems for mutual funds and ETFs. Its system assigns stars ranging from 1 to 5 based on how well a fund has performed compared to its peers (funds with similar investment strategies). Morningstar compares funds based on their historical risk-adjusted returns, which is a measure of how much money a mutual fund made relative to the level of risk over a specific time period. For example, if two funds both rose 10% over the past year, the less risky fund would have a better risk-adjusted return.

Funds receive a star rating when they have existed for more than three years. As you can see in the distribution of rating assignments, within each Morningstar category, the top 10% of funds receive 5 stars; the bottom 10% receive 1 star. Funds are rated over their three-, five- and 10-year time periods, if applicable, and these three ratings are combined to produce an overall rating.

Keep in mind that stars are assigned to each fund relative to the other funds in its category. For the approximately 10,000 funds in existence, Morningstar has 120 categories, which vary depending on the type of securities the fund holds.

Ratings are entirely based on a mathematical evaluation of past performance. So, while Morningstar is a simple metric to compare funds, it’s only one way to assess a fund and should only be used as a part of the decision process. Importantly, no one can predict future performance and a star rating cannot help you assess whether the fund is right for you or how tolerant you are of risk.

Jemma Everyday Wisdom: Although there are a number of metrics that can be used to evaluate the quality of an investment, a fund’s Morningstar rating can be used as a good starting point to help narrow down your selection process.