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How to use Morningstar ratings to analyse mutual funds

By Finserv MARKETS - Aug 2,2019
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How to use Morningstar ratings to analyse mutual funds

What is the Morningstar rating?

Morningstar, a global investment research firm, ranks mutual funds and exchange-traded funds based on a purely quantitative calculation to help investors analyse funds for their portfolio. The ratings run from one to five (five being the highest) and are based on the historical risk-adjusted performance, as well as the costs (such as expense ratio), of a fund in comparison to others in the same category. The risk associated with a fund is assessed based on its standard deviation, or variations in a fund’s monthly returns, which is basically a measure of how volatile a fund is.

This means that if a fund has given high returns, but also experienced high volatility in achieving those returns, then its final risk-adjusted Morningstar rating will be lower than a fund that has achieved slightly lower returns but was steady and low-risk. Downside variations, of course, have a higher premium. A fund can only be rated by Morningstar if it has been in existence for at least three years. The risk-adjusted and cost-adjusted ratings are plotted over three, five, and ten years along a bell curve, and are made available at the end of every month.

How should the Morningstar rating be used by investors?

The firm makes it very clear that these ratings are a historical or backwards-looking measure of a fund’s performance and not a predictive analysis of how a fund is likely to perform in the future. If you’re looking to invest in a fund, The Star Rating is a good starting point for you to begin your evaluation process and look at the best performing mutual funds. You can use Morningstar data and ratings to study the track record of a particular fund, examine the factors that drove its performance and whether these factors (including market conditions) are likely to sustain.

It’s important for you to remember that a 5-star or 4-star rated fund isn’t guaranteed to give you the best returns — it’s simply a measurement of how it’s performed so far. It could also have a high rating because of prevailing market conditions that are unlikely to continue or because of a strategy that is unsustainable in the long-term. Therefore, it is imperative that you don’t rely exclusively on these backwards-looking and historical ratings of a fund and do your homework properly before you decide to invest.

If you’re looking for predictive analysis of how a fund is likely to perform in the future, you should study the Morningstar Analyst Ratings, a feature introduced in 2011.

What is the Morningstar Analyst Rating?

While the star ratings by Morningstar are an achievement test for mutual funds, the Analyst ratings are more of an aptitude test. The Analyst Rating is a qualitative, forward-looking measurement of the long-term potential of a fund to outperform its peers over a full market cycle of at least five years. The ratings take into account the five Ps that drive mutual fund performance: people, parent, process, performance, and price. Funds are analysed based on their competitive advantage across the five Ps and are rated Gold, Silver, Bronze, Neutral or Negative based on this analysis. Along with a rating, Morningstar analysts also provide context and background to explain a fund’s rating as well as information about the five Ps pertaining to the fund.

Decoding the Morningstar Analyst Rating

If a fund gets a Gold rating by Morningstar, it means that it has distinguished itself across the five parameters that they look at, and is likely to outperform its peers in the same category. A Silver fund has distinguished itself across some parameters and has the analysts’ high conviction. A Bronze fund has a positive rating because its strengths outweigh its disadvantages. A Neutral fund is not likely to deliver a standout performance and has no clear competitive advantages or obvious disadvantages. A Negative fund is likely to under perform in the long-term and would make for a poor investment.

Together, the Star rating and the Analyst rating can be important tools to help you decide which funds to include in your portfolio — provided you use them right. For instance, you shouldn’t use the Analyst ratings to compare funds across categories — a Silver-rated small-cap mutual fund isn’t necessarily better than a Bronze-rated large-cap mutual fund. You should first decide what kinds of funds you need in your portfolio and what kind of asset allocations you’d like to make.

Once you have that ready, you can look at Star ratings to see the historical risk-adjusted performance of funds in the same category, and the Analyst ratings to look at the risk-adjusted outlook on the performance of those funds. It’s likely that you’ll find a five-star rated fund with a Neutral or Negative rating — just because a fund has performed well in the past doesn’t mean that it will continue to do so in the future. Similarly, a two-star rated fund could have a Silver or Gold rating if analysts feel that it has the potential to outperform its peers over a market cycle.

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