What Is the Morningstar Risk (Star) Rating?
The Morningstar risk rating—commonly called the Morningstar star rating—is a quantitative, category-relative ranking that rates publicly traded mutual funds and ETFs on a 1–5 scale (1 = lowest relative risk-adjusted performance, 5 = highest). It is intended as a quick, standardized signal of how a fund’s historical returns looked after accounting for risk relative to its peer group (its Morningstar category). The rating is a starting point for further research, not a buy/sell recommendation. (Investopedia; Morningstar)
How the Rating Is Determined (Overview)
– Peer-group comparison: Funds are compared only to other funds in the same Morningstar category (e.g., large-cap growth, municipal bond).
– Risk-adjusted return: Morningstar computes risk-adjusted returns based on monthly returns and places a larger emphasis on downside variability. Funds with the same nominal return but higher volatility receive worse ratings.
– Percentile cutoffs: Within each category, Morningstar assigns ratings by percentile: the bottom 10% are “low” (1 star), next 22.5% are “below average” (2 stars), middle 35% are “average” (3 stars), next 22.5% are “above average” (4 stars), and top 10% are “high” (5 stars).
– Timeframes: Morningstar looks at multiple periods (3-, 5-, and 10-year) when available and combines those period measures into an overall score. Funds with less than three years’ history are not given a star rating. (Investopedia; Morningstar)
What a Morningstar Risk Rating of 5 Stars Means
A 5‑star rating indicates the fund ranked among the top decile in its category for risk-adjusted return over the measured period(s). In plain terms: historically, investors in that category who picked that fund would have received relatively high returns for the level of risk the fund displayed—relative to peers in the same category. It does not guarantee future outperformance.
Concrete Example (from Investopedia)
– iShares Nasdaq Biotechnology ETF (IBB): Morningstar classified IBB as an “above-average” risk fund (three stars on the three-, five-, and 10-year bases, per Investopedia). Over the 10-year span cited, IBB produced an annualized total return of 15.38% vs. 11.59% for the S&P 500—illustrating that strong returns do not automatically equal a top star rating if volatility and peer comparisons are factored in. (Investopedia)
Strengths of the Morningstar Rating
– Easy to use: Condenses a lot of historical, risk‑adjusted performance information into a single, comparable number.
– Category-relative: Helps investors compare funds that pursue similar objectives and faces similar market environments.
– Widely available and commonly used: Many investors and publications rely on Morningstar as a standardized yardstick.
Limitations and Criticisms
– Backward-looking: The rating is based on past performance and volatility; it is not a forward-looking predictor of future returns.
– Category isolation: Because ratings are relative to a fund’s category, a “5-star” fund in a generally poor-performing category may still be inferior to many funds in other categories. Critics say this can make ratings sensitive to market regimes (e.g., bull vs. bear markets).
– Mixed predictive power: Academic and industry studies (e.g., a Vanguard study) found Morningstar ratings were not reliable predictors of future outperformance versus benchmarks; in some cases one‑star funds later produced greater excess returns. (Investopedia; Vanguard)
– Not a complete risk profile: The star rating does not replace analysis of drawdowns, liquidity, concentration risk, manager risk, macro exposures, or tail risk measures.
Other Providers and Complementary Tools
– Alternatives: Lipper (Refinitiv), S&P, Zacks, and TheStreet provide fund ratings using different methodologies.
– Complementary metrics to check: standard deviation, Sharpe ratio, Sortino ratio, maximum drawdown, beta, downside deviation, alpha vs. relevant benchmarks.
– Qualitative ratings: Morningstar also provides analyst-driven qualitative ratings (e.g., Morningstar Analyst Ratings such as Gold/Silver/Bronze) that factor in stewardship, process, and manager quality—useful in addition to the star rating.
How Reliable Are Morningstar Ratings?
They are a useful screening tool but not a sole decision-maker. Research (for example, Vanguard’s study noted that ratings did not reliably predict future outperformance) suggests investors should not assume a high star rating guarantees future success. Use the rating as one input among many. (Vanguard; Morningstar)
Practical Steps: How to Use Morningstar Risk Ratings When Selecting Funds
1. Start with the rating—then dig deeper
– Use star ratings to narrow a long list of funds to a manageable shortlist.
– Confirm the fund’s Morningstar category is appropriate for the fund’s stated strategy.
2. Compare within and across categories
– Look at the fund’s percentile within its category, not just the star count.
– If comparing across categories (e.g., large-cap vs. small-cap), be mindful that category risk profiles differ.
3. Review time-period ratings
– Check 3-, 5-, and 10-year ratings (when available). A fund with steadily improving ratings might reflect positive changes; a fund with declining ratings may warrant closer inspection.
4. Examine additional quantitative risk metrics
– Standard deviation, Sharpe ratio, Sortino ratio, maximum drawdown, downside deviation, beta, and historical worst-case drawdown.
– Look at trailing returns alongside these risk metrics.
5. Inspect fund fundamentals
– Holdings concentration, sector and style exposures, expense ratio, turnover, tax efficiency, manager tenure, and assets under management.
6. Read qualitative research
– Consult Morningstar analyst reports (Gold/Silver/Bronze/Neutral/Negative) or independent research to assess process, people, and stewardship.
7. Check fees and taxes
– Lower expense ratios and tax-efficient structures can materially affect after-tax investor returns.
8. Align with investor goals and time horizon
– Ensure the fund’s risk profile matches your risk tolerance, investment horizon, and portfolio role.
9. Perform scenario and stress checks
– Consider how the fund behaved in market downturns relevant to your horizon (e.g., 2008, 2020 selloffs).
10. Reevaluate periodically
– Ratings and fund characteristics change. Review holdings, performance, and ratings at least annually or after major market moves.
Quick Checklist for a Fund Decision Using Morningstar Ratings
– Is the fund’s category appropriate for the stated strategy?
– What is the star rating and how has it changed across 3/5/10 years?
– What are volatility and downside measures (STD, Sortino, max drawdown)?
– What is the expense ratio and turnover?
– Who manages the fund and how long have they been in place?
– Are the holdings concentrated or broadly diversified?
– What do qualitative analyst reports say about process and governance?
– Does the fund fit your time horizon and risk tolerance?
Bottom Line
Morningstar’s star (risk) rating is a widely used, category-relative measure of past risk‑adjusted performance. It’s a useful first screen but should not substitute for a thorough review of a fund’s risk metrics, fees, holdings, manager quality, and alignment with your investment goals. Combine Morningstar ratings with other quantitative and qualitative research before making investment decisions.
Sources and Further Reading
– Investopedia. “Morningstar Risk Rating.” Accessed [Investopedia link provided by user].
– Morningstar. “What Is the Star Rating?” (Morningstar’s explanations and methodology pages).
– Vanguard. “Mutual Fund Ratings and Future Performance.” (study of rating predictive power).
– Morningstar research and fund pages for individual fund data (e.g., IBB example referenced above).
If you want, I can:
– Walk through this checklist for a specific fund you’re considering.
– Produce a side‑by‑side comparison of 3 candidate funds using Morningstar and other risk measures.