Understanding the Star Rating and Fund Analyst Picks

This column first appeared in Kiplingers.

One thing I've learned over my many years at Morningstar is that I can't write about the Morningstar Rating for funds and the Fund Analyst Picks enough. Each year in Morningstar FundInvestor I describe how the ratings and the picks performed and how best to use them. Yet the letters and e-mail messages keep coming--how do they work, what should I do with them?

I understand why all the questions. The stars and picks are complicated and important. The star ratings and picks can be a huge help in building a good portfolio of funds. But first you have to understand a little bit about how they work to make use of them.

Here's the key: The Fund Analyst Picks are forward-looking, subjective recommendations of funds that analysts think have the greatest chance of success. The star rating is a backward-looking, quantitative measure of past returns that is adjusted for risk and sales charges.

Inside the Star Rating
The star rating ranks funds based on relative performance within their category over the trailing three-, five-, and 10-year periods. We subtract sales fees from those returns, and we penalize those that take a lot more risk than their peers while rewarding those that take on much less risk. Our risk measure captures volatility with a particular emphasis on price declines. The result of all this is a number reflecting each fund's risk and load-adjusted returns. We rank them and award the top 10% 5 stars, the next 22.5% 4 stars, the middle 35% 3 stars, the next 22.5% 2 stars, and the bottom 10% 1 star. In other words, we grade on a curve and we don't rate everything a buy the way Wall Street does. Finally, we roll up the star ratings for the three, five, and 10-year periods into one overall rating.

We made one big improvement in 2002, when we began comparing each fund only with its peers--funds in the same category--instead of with all U.S. stock funds or all international funds. By doing that, we found that the star rating does have some predictive power. By that I mean that 5-star funds as a group beat 4-star funds, which in turn beat 3-star funds and so on down the line. The results so far indicate that 5-star funds do better than average and 1-star funds do worse, but only by modest amounts.

The star rating's chief limitation is that it doesn't reflect recent fundamental changes such as manager changes or asset bloat. The upshot of that and the performance studies is that the rating should be used as a screen to narrow your list, but don't ask it to make your investment decisions.

Discriminating Picks
The Fund Analyst Picks start where the ratings end. Whereas 10% of funds with three-year records or longer receive 5 stars, only about 2% make our list of Analyst Picks. These are the funds that we believe have the strongest fundamentals and therefore the greatest likelihood of success over the long haul. The most important fundamentals are management, strategy, long-term performance, costs, and stewardship.

We crunch numbers, interview fund managers, and visit fund companies to figure out who has a real competitive advantage. Most of our picks rate 4 or 5 stars, but not all do. If a fund's fundamentals have drastically changed for the better or are just not fully captured by trailing returns, we'll make it a pick even if it's just 1 or 2 stars.

We've found that about two thirds of our picks outperform their category over time. The picks list is available to Morningstar FundInvestor subscribers and premium members of www.Morningstar.com. Premium members can find our picks  here.

So, the star rating is a good gauge of past performance that needs to be supplemented with fundamental research. The picks list adds that in, enabling you to go right to the best in class.