Morningstar Mutual Fund Ratings

Morningstar offers ratings of one to five stars for most mutual funds. They have excellent researchers, and used the right way, they can help you choose the best performing funds. However, you have to dig in a little deeper than simply the ratings in order to benefit from them. Often, a two star fund is a smarter buy than a five star fund for a given investor. The biggest mistake investors make is comparing funds in an apples to oranges manner.

Morningstar ratings are basically an indication of a mutual fund's comparison to similar funds as well as its comparison to a stock index that Morningstar thinks the fund should compare favorably against. Therefore, if a fund charges a low fee and has a superb management, it will perform better than similar funds in a given category and will compare favorably to its related index. Consequently, it will have a higher Morningstar rating.

Good funds get good ratings, so what's the problem? The problem comes from the fact that funds exist for an infinite number of reasons, and Morningstar does not use enough indices and fund categories to fairly evaluate all the funds.

For example, let's take a mutual fund with a stated goal to specialize in the highly cyclical semiconductor industry. The fund may have the lowest fee ever and the best fund manager around, however, if the semiconductor industry is slumping for a given year, it will not do as well as mutual funds that don't specialize in the semiconductor industry. Now Morningstar may compare that fund to technology funds that don't specialize in semiconductors and it may compare it to the more general NASDAQ-100 index. That is how a good fund can receive a bad rating. MOreover, since semiconductors are cyclical, it is better to buy after a down cycle than an up cycle, so it can be argued that it is better to buy mutual funds in cyclical industries that have a low Morningstar rating. Similarly, when the semiconductor fund is rallies for a year, a fund with very high fees and a horrible manager can have a better return than the collection of funds used by Morningstar for comparison.

Another example that applies to less hands on investors are the target funds that are growing in popularity. These funds have a target date for retirement and gradually change the investment mix to a more conservative stance as the retirement date approaches. These funds are great for investors that want an easy investment vehicle for their retirement savings. They are highly diversified and are generally compared to the S&P 500 and Wilshire 5000 for Morningstar ratings purposes. Since these funds include some bond holdings, they will underperform the broad indices on years that see a sharp increase in stock prices. Therefore they will have high Morningstar ratings after a sharp runup of stocks and low Morningstar ratings after a sharp downfall. If investors go solely by Morningstar ratings for these funds, they will buy high and sell low.

So how should Morningstar ratings be used? First choose your allocation and type of fund you're looking for, then use the ratings as a relative indicator among the funds in a group. If you feel you want more exposure to the semiconductor industry because you think that industry is going to enjoy an up-cycle, then look at all the semiconductor mutual funds and choose the one with the best rating. Similarly, if you're looking for a 2020 retirement target mutual fund, look at the products from Vanguard, Fidelity, Schwab, etc. for that retirement date and then choose the one with the highest rating.

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