What's Behind the Morningstar Ratings?

Question: What are the key differences between your star ratings for mutual funds, stocks, and exchange-traded funds?

Answer: Finding the right investments can be a daunting process. To help alleviate the burden of choice overload, Morningstar has created an array of tools to help investors assess an investment's key characteristics at a glance.

The Morningstar Style Box for mutual funds, for example, helps you quickly see how a fund actually invests the bulk of its assets. Meanwhile, the Morningstar Rating for funds, introduced in 1985, helps investors quickly gauge how a fund has balanced risk and reward. We've since introduced star ratings for individual stocks and exchange-traded funds.

You're correct that there are some important distinctions between these ratings, and it's important to bear them in mind if you're using these ratings as part of your security-selection process. To help shed light on the key similarities and differences, we'll provide a brief overview of what the star ratings indicate for each investment type, how they're calculated, and how to (and how not to) use them.

Star Rating for Mutual Funds
Snapshot
Morningstar's star rating for funds measures how well a fund has balanced risk and reward relative to its peers. Keep in mind that fund star ratings are strictly returns-based and don't take into account fund fundamentals, such as manager changes.

How It's Calculated
The star rating for funds is strictly quantitative--meaning that our analysts' opinion of a fund has no bearing on its star rating. (Note that Morningstar is rolling out qualitative Analyst Ratings for funds in the fourth quarter of this year, however.) Instead, a fund's rating is based on its performance versus its peers' during the past three-, five-, and 10-year periods. A fund must have at least a three-year track record to be eligible for a rating.

The return component of the rating is fairly straightforward, taking into account the fund's return during each month over the past three-, five-, and 10-year periods and reducing that return to account for any expenses or sales charges shareholders would've had to pay. Next, Morningstar adjusts the fund's monthly load- and expense-adjusted returns for the risk-free rate. Because investors always have an option to invest at the risk-free rate, Morningstar measures only the amount by which fund returns have exceeded that risk-free rate.

The risk component of the rating is based on "expected utility theory," which recognizes that investors are more concerned about potential losses than unexpected gains and are therefore willing to trade some fraction of their expected return in exchange for a greater certainty of return. Thus, the risk measure penalizes funds more when they exhibit downside volatility versus a risk-free rate of return than it does when they exhibit upside volatility. However, to help reduce the possibility of strong short-term performance masking the inherent risk of a fund (as was the case with many technology-stock-laden funds in the late 1990s), the rating accounts for all variations in a fund's monthly performance during the past three-, five-, and 10-year periods, not just the downward variations.

Once we've arrived at a fund's risk and return scores, funds are then ranked and rated within their Morningstar categories for each time period, with stars assigned on a bell curve scale. For example, we would evaluate a mid-cap blend fund by comparing how it has performed relative to other funds in the mid-cap blend category. The bottom 10% of the funds in the mid-blend category are given a 1-star rating, the next 22.5% get a 2-star rating, the next 35% get a 3-star rating, the next 22.5% get a 4-star rating, and the remaining 10% get a 5-star rating. Funds receive star ratings for each time period (three-, five-, and 10-year), and the overall star rating is a weighted average of the different time periods, with an emphasis on the longer-term ratings. As such, the star rating favors funds that have consistent long-term track records. We recalculate funds' ratings every month.

How to Use It (and How Not to)
The most prudent way for investors to use the star rating for funds is to help narrow down the pool of investment options. For example, Morningstar subscribers could use the Basic Screener or  Premium Fund Screener to seek out no-load large-value funds with below-average costs, long-tenured managers, and star ratings of at least 3, thereby winnowing down their choices to a more manageable group of funds worthy of further research.

On the flip side, the star rating should never be used as the be-all and end-all metric for identifying superior funds. While our research confirms that 5-star rated funds largely outperform 1-star rated funds, keep in mind that these ratings are based on historical returns and are not reliable predictors of future performance. Also note that every category has 5-star rated funds, but not all categories are equally suitable for most investors. A 5-star precious-metals fund might make sense for only a small population of investors, while a 5-star large-blend fund might make sense for most investors.

Star Rating for ETFs
Snapshot
The ETF star rating is largely identical to that of the Morningstar Rating for funds. However, we don't just compare ETFs with other ETFs for the purpose of the rating. Because the traditional mutual fund universe is much larger and forms a more representative peer group for comparisons than does the ETF universe, we use both peer groups as the competitive universe when calculating ETF star ratings. For example, a mid-blend ETF would be compared alongside other mid-blend ETFs as well as traditional mid-blend mutual funds for the purpose for the star rating.

How It's Calculated
We use basically the same methodology for both traditional mutual fund and ETF star ratings. However, in order to make ETF star ratings directly comparable to open-end funds, Morningstar uses an ETF's total return based on changes in its net asset value rather than its market price total return. (Please note, however, the two statistics can differ, as referenced in this article.)

How to Use It (and How Not to)
ETF star ratings, like those of mutual funds, rely on historical data, which means that investors should not rely on them to forecast future performance.

Rather, investors who are shopping for ETFs should also be mindful of other considerations, including strategy (particularly for actively managed funds), tax efficiency, trading costs, and expenses. Morningstar's ETF Analyst Reports do a nice job of summing up all of these variables, and they also include price/fair value ratios for equity ETFs based on the average weighted price/fair value ratios of all of the securities in the portfolio.

Star Rating for Stocks
Snapshot
Whereas the mutual fund and ETF star ratings are both backward-looking quantitative measures of a fund's risk/reward profile, the stock star rating is completely different. It's both quantitative and qualitative, for starters, and it's meant to be forward-looking. If a stock has a high star rating, that means we think the shares have good upside potential and that investors should consider buying them.

How It's Calculated
The Morningstar Rating for stocks is calculated by comparing a stock's current market price with Morningstar's estimate of the stock's fair value. Morningstar analysts arrive at fair value estimates for their companies by estimating a company's future financial performance using a detailed discounted cash flow model that factors in projections for, among other things, the company's sales, profitability and financing. Morningstar's analysts also consider the competitive advantages and staying power of the businesses (that is, their moats) when projecting these figures.

Generally speaking, stocks trading at large discounts to our analysts' fair value estimates will receive higher (4 or 5) star ratings, and stocks trading at large premiums to their fair value estimates will receive lower (1 or 2) star ratings. Stocks that are trading very close to our analysts' fair value estimates will receive 3-star ratings. Stock star ratings are recalculated daily, to reflect changes in share price relative to our analysts' estimates of their fair value, but they won't necessarily change on a daily basis.

The higher a company's risk, the cheaper its stock has to be to earn a 5-star rating. For example, in order for a firm with below-average business risk to receive 5 stars, it needs to be just 15% below analysts' fair-value estimate, while an above-average-risk stock would require a 35% discount to reach 5-star status.

Unlike mutual funds and ETFs, where there's a fixed distribution of high and low star ratings within each peer group, it's highly possible that a given stock sector will consist entirely of high- or low-rated companies. Furthermore, there is no predefined distribution of stars in determining a stock's star rating--thus, for example, the number of stocks earning 5 stars can fluctuate daily.

How to Use It (and How Not to)
In contrast with the fund and ETF star ratings, which measure only risk and reward, the stock star rating is more holistic and forward-looking.

When choosing specific stocks, investors can turn to the Basic or  Premium Stock Screener to quickly filter for ones that meet certain criteria. For example, screening for 5-star domestic stocks with wide moats yields 10 offerings.

In contrast with the fund and ETF star ratings, the stock star rating aims to guide investors' buy/sell decisions. But keep in mind that not every 5-star stock will be right for every investor; risk tolerance should also play a role. Moreover, investors should bear in mind their own situations, including the tax and transaction costs, before dumping 1-star stocks.

Although the stock star rating helps expose undervalued stocks and flags those that are pricey, you'll need to check out the stock's Analyst Report to see if you agree with the reasoning behind the star rating. Then, you can evaluate whether the stock makes sense in your portfolio given your risk tolerance and other companies you already own.