What Is Morningstar Rating?
The Morningstar rating is a quantitative, backward-looking assessment system for investment funds, including mutual funds and exchange-traded funds (ETFs), provided by the investment research firm Morningstar, Inc.95, 96 This rating system falls under the broader financial category of Investment Research and Fund Evaluation, offering investors a quick, at-a-glance measure of a fund's historical risk-adjusted return relative to its peers.93, 94 Funds are assigned a rating from one to five stars, with five stars indicating the best past performance when adjusted for risk.90, 91, 92 The Morningstar rating serves as an initial tool to help investors screen and analyze potential opportunities for their investment decisions.89
History and Origin
Morningstar, Inc. was founded by Joe Mansueto in 1984 in Chicago.88 The Morningstar Rating for mutual funds, commonly known as the "star rating," debuted in 1985.86, 87 Initially, funds were compared within four broad asset classes.85 However, the methodology was revised in 2002 to rank and rate funds within more specific categories, eventually expanding to over 50 categories. In 2006, the Morningstar rating system was extended to include exchange-traded funds, reflecting the growing prominence of these financial instruments. The system was designed to provide investors with an easily understandable indicator of a fund's past performance relative to its peer group.84
Key Takeaways
- The Morningstar rating is a quantitative, backward-looking measure of a fund's historical risk-adjusted return compared to its peers.81, 82, 83
- Funds are rated on a scale of one to five stars, with five stars being the highest rating, awarded to the top 10% of funds in a given category.79, 80
- The rating primarily considers a fund's performance over three, five, and ten-year periods, emphasizing downside volatility.77, 78
- It is intended as a starting point for fund evaluation and should not be the sole basis for investment decisions, as past performance is not a guarantee of future results.75, 76
- Morningstar also offers other ratings, such as the forward-looking Morningstar Analyst Rating and the Morningstar Sustainability Rating for ESG considerations.73, 74
Formula and Calculation
The Morningstar rating is not derived from a single, simple formula in the way one might calculate a financial ratio. Instead, it is the result of a multi-step, quantitative methodology that assesses a fund's historical risk-adjusted return.71, 72
The core of the Morningstar rating calculation involves the Morningstar Risk-Adjusted Return (MRAR) measure.69, 70 This measure accounts for variations in a fund's monthly excess performance, placing greater emphasis on downward fluctuations and rewarding consistent fund performance.67, 68 Morningstar uses expected utility theory to determine how much return an investor is willing to trade off to reduce the risk of loss.66
The process generally involves:
- Calculating Monthly Total Returns: For each fund, monthly total returns are calculated, accounting for all loads, sales charges, and redemption fees.64, 65
- Determining Risk Penalty: A risk penalty is applied based on the amount of variation in the fund's monthly return, with an emphasis on downside variations. The greater the variation, the larger the penalty.62, 63
- Calculating Risk-Adjusted Return: The risk penalty is subtracted from the fund's total return to arrive at the risk-adjusted return.61
- Peer Group Comparison: Funds are then compared against others within their specific Morningstar Category, which groups funds based on their underlying holdings and investment strategy.58, 59, 60
- Assigning Stars: Within each Morningstar Category, funds are ranked based on their risk-adjusted returns over three, five, and 10 years (if available). The stars are assigned based on a bell-curve distribution:
For funds with less than 10 years of history, weighted averages of the available periods are used. For instance, a fund with three to five years of history receives a rating based solely on its three-year performance, while a fund with five to 10 years combines 60% of its five-year rating and 40% of its three-year rating. Funds with 10 or more years of data use a 50% 10-year, 30% five-year, and 20% three-year weighting.49, 50 Funds must have at least three years of performance history to receive a Morningstar rating.48
Interpreting the Morningstar Rating
Interpreting the Morningstar rating involves understanding its relative and historical nature. A five-star Morningstar rating signifies that a fund has performed exceptionally well on a risk-adjusted return basis compared to its peers within the same Morningstar Category over the evaluated periods (three, five, and 10 years).46, 47 Conversely, a one-star rating indicates the fund has underperformed relative to its peers.45
It is crucial to recognize that the Morningstar rating is backward-looking, meaning it reflects past fund performance and does not predict future results.43, 44 A high rating does not guarantee future outperformance, nor does a low rating imply continued underperformance.42 Investors should use the Morningstar rating as a starting point for further research, delving into factors such as the fund's investment strategy, expense ratio, manager tenure, and alignment with their personal financial goals and risk tolerance.40, 41
Hypothetical Example
Consider an investor, Sarah, who is looking for a large-cap equity fund for her portfolio management strategy. She uses a fund screener and filters for funds with a Morningstar rating of four or five stars within the "U.S. Large Blend" Morningstar Category.
One fund, Fund A, has a five-star Morningstar rating. This means that, over the relevant periods (e.g., three, five, and 10 years), Fund A's risk-adjusted return has been in the top 10% of all funds categorized as U.S. Large Blend. Another fund, Fund B, has a three-star Morningstar rating, indicating its risk-adjusted performance was in the middle 35% of its peers.
Sarah understands that while Fund A has historically performed better than Fund B and most other funds in its category, this is not a guarantee of future returns. She then proceeds to investigate other factors for both funds, such as their individual holdings, the experience of the fund manager, and the overall expense ratio to make an informed decision beyond just the star rating.
Practical Applications
The Morningstar rating system is widely applied in various aspects of investment analysis and selection.39 Individual investors and financial advisors frequently use it as an initial screening tool to narrow down the vast universe of mutual funds and ETFs.37, 38 For example, an advisor might use the Morningstar rating to identify funds that have historically offered strong risk-adjusted returns within a particular asset allocation segment, such as international equities or fixed income.36
Furthermore, the Morningstar rating provides a common benchmark for comparing the historical performance of funds within similar market capitalization ranges and investment styles.34, 35 This allows for a standardized assessment across diverse fund offerings. Academic research has also utilized Morningstar ratings to study various aspects of portfolio management and investment performance, including the impact of costs on target-date funds.33
Limitations and Criticisms
Despite its widespread use, the Morningstar rating has several notable limitations and criticisms. A primary concern is its backward-looking nature; the rating reflects only historical fund performance and is not predictive of future returns.31, 32 A fund with a five-star rating today might not maintain that level of performance in the future, especially if underlying factors such as management or investment strategy change.28, 29, 30
Critics also point out that the Morningstar rating does not explicitly account for all qualitative factors that can impact a fund's future, such as changes in fund management or shifts in the economic environment.26, 27 For instance, if a highly-rated fund's manager, responsible for its past success, departs, the fund might retain its high rating for some time even with a new manager.25
Moreover, the rating is relative to a fund's specific category. This means a five-star fund in a highly volatile sector may still carry significant volatility and risk, even if it has outperformed its peers.24 Some studies have indicated that while higher-rated funds tend to outperform lower-rated funds within their categories, the Morningstar rating is not a strong predictor of outperformance against a benchmark index.23 A 2006 Kiplinger article noted that the system "doesn't consider manager changes, and it ranks older funds over longer periods of time than it does newer funds, which can create an apples-and-oranges comparison."22
Morningstar Rating vs. Lipper Leader
The Morningstar rating and the Lipper Leader rating are two prominent systems used to evaluate mutual funds and ETFs, yet they differ in their methodologies and emphasis. Both aim to provide investors with a simplified way to compare fund performance.
The Morningstar rating primarily focuses on historical risk-adjusted return, assigning stars based on how well a fund has balanced return and risk compared to its peers within specific Morningstar Categories.20, 21 It calculates a single star rating (1-5 stars) for overall risk-adjusted performance.19
In contrast, the Lipper Leader rating system evaluates funds based on whether they meet specific investment goals across several distinct categories.18 Lipper assigns ratings (also on a 1-5 scale) for different metrics, including:
- Total Return: Reflects actual rate of return over a specific period.17
- Consistent Return: Measures how consistently a fund has provided returns.16
- Capital Preservation: Assesses a fund's ability to minimize losses in various markets.15
- Expense: Ranks funds based on their expense ratio relative to peers.14
- Tax Efficiency: For U.S.-based funds, measures how well a fund manages to postpone taxes.13
This means a single fund can be a "Lipper Leader" in one category (e.g., Capital Preservation) but not in another (e.g., Consistent Return), whereas the Morningstar rating provides one comprehensive star rating. While Morningstar's star rating is purely quantitative and backward-looking, Morningstar also offers forward-looking Analyst Ratings.12 Lipper's system is also retrospective.11
FAQs
What does a 5-star Morningstar rating mean?
A 5-star Morningstar rating indicates that a fund's historical risk-adjusted return has been in the top 10% of its peer group within its Morningstar Category over the measured periods (three, five, and 10 years).8, 9, 10 It signifies superior past performance relative to similar funds, but it is not a prediction of future results.
Are Morningstar ratings reliable for predicting future performance?
No, Morningstar ratings are not designed to predict future fund performance.7 They are backward-looking quantitative measures based on historical data. While they can serve as a useful starting point for research, investors should not rely solely on them for making investment decisions.
How often are Morningstar ratings updated?
Morningstar ratings are updated monthly.5, 6 This regular recalculation reflects the most recent fund performance and risk data.
Can a new fund receive a Morningstar rating?
Generally, a fund must have at least a three-year performance history to be eligible for a Morningstar rating.3, 4 Newer funds will not receive a star rating until they meet this minimum history requirement.
Does Morningstar consider fees in its ratings?
Yes, the Morningstar rating indirectly accounts for fees because the calculation uses total returns, which reflect the impact of loads, sales charges, and ongoing expenses like the expense ratio.1, 2 The returns used in the rating are after these costs have been deducted.