Broker Check

Morningstar Star Ratings

July 10, 2015

Morningstar is a third party research company that reviews and analyses mutual funds and other investments.  The rating system they developed, giving funds a one to five-star rating system has become so widely known because of its simplicity.  Investors looking to use it as an easy fund pick should beware.

As a matter of disclosure, I have paid Morningstar for their information for more than 10 years as a professional and they have published articles of mine on their website.  To me, the money we pay to Morningstar as investors, investment managers, financial advisors, brokers and other investment professionals is well worth it.  They are far and away the most widely used company that provides this service.  They are great at what they do.  They provide great depth and objectivity in their analysis.  Many companies tout the star ratings of their funds.  Those funds should be proud of their status.  The problem comes when investors do not truly understand what Morningstar means by the star rating and what it often means to those investments.

The greatest risk comes to the quick-fix do-it-yourself investors.  Those investors that pick the mutual funds in their 401(k) strictly by scanning the fund list to see which funds have the most stars and the best returns last year.

Star ratings are meant to be a guide that, according to Morningstar ‘gives you a first glance at how consistent and reliable the fund is as well as its returns.’  People often forget that it is a "first glance".  Each of us has different investing needs.  That is why Morningstar provides the in-depth analysis and dizzying array of figures on so many investments.   If the star rating said it all why bother with the rest.

In 2010 at the Morningstar Investment Conference, Don Phillips, President of Fund Research at Morningstar addressed studies that are done from time to time, which tend to show that Morningstar’s star ratings are not reliable predictors of future performance.  He said ‘The star rating is a grade on past performance. It’s an achievement test, not an aptitude test…We never claim that they predict the future.’

The next time that someone points out the star rating of a fund remind them of the famous quote from Wayne Gretzky ‘A good hockey player plays where the puck is. A great hockey player plays where the puck is going to be.’  Then tell them to read Top 10 mutual fund qualities and to do a little more research.