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How Morningstar Rates Mutual Funds

Financial Planning

July 2016

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How Morningstar Rates Mutual Funds

Mutual funds started to become popular back in the 1980s. However, there was one problem. Lack of information. While stock investors could get information on individual companies, mutual funds were comprised of up to hundreds of companies in different allocations, so individual holding research was futile.

Then along came Morningstar founder Joe Mansueto, who formed the company in order to provide readily available information about mutual fund performance, along with analysis and commentary. Established in 1984, Morningstar is now well-reputed as an independent investment research firm that offers assessments for all types of investments, including stocks, mutual funds and exchange traded funds.

Morningstar’s publication, The Mutual Fund Sourcebook, is a quarterly guide that provides performance data, portfolio holdings and other information on the majority of mutual funds currently available. The company also boasts Morningstar data and proprietary analytical tools, including the Morningstar Rating system for investments and the Morningstar Style Box that depicts each fund’s overarching investment style.

Morningstar is probably best known for its mutual fund ratings, ranging from one to five stars. These ratings gauge the performance of each mutual fund within the context of its risk profile as compared to similar funds. Ratings also adjust for the individual sales charges for each fund. The ratings system covers more than 100 different fund categories by different share classes, which are subject to various fee structures and therefore yield total return deviations.

Within each mutual fund category, Morningstar assigns five stars to the top 10 percent of funds and only one star to the bottom 10 percent. Funds with at least three years of performance are rated by separate time periods (three, five and 10 years); the company doesn’t rate funds with less than a three-year history.

The following factors are combined to create an overall rating for each mutual fund:

  • If a fund is three to five years old, its overall star rating will be the three-year rating;
  • If a fund is five to 10 years old, its overall rating will be 60 percent of the five-year rating and 40 percent of the three-year rating;
  • If a fund is more than 10 years old, its overall rating will be 50 percent of the 10-year rating, 30 percent of the five-year rating and 20 percent of the three-year rating.

The Morningstar Style Box is a visual graphic consisting of a nine-square grid. The Style Box for equity funds features a horizontal axis depicting value, growth and blend investment management styles, which is cross-sectioned against a vertical axis for large-, mid- or small-cap equities. To demonstrate a mutual fund’s style, for example, a filled-in box that meets at growth and large-cap would indicate that the majority of the fund’s holdings are large-cap and the fund manager uses a growth style of investment management.

The Fixed-Income Style Box depicts a horizontal axis for duration (short/limited, intermediate/moderate, long-term/extensive), which is an indicator of a fund’s interest rate sensitivity. The vertical axis depicts a fund’s credit quality as either low, medium or high.

The Morningstar Rating system for investments and the Morningstar Style Box combine to provide both investors and money managers a convenient way to evaluate mutual funds, particularly in comparison with similar types of investment options.

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These articles are intended to provide general resources for the tax and accounting needs of small businesses and individuals. Service2Client LLC is the author, but is not engaged in rendering specific legal, accounting, financial or professional advice. Service2Client LLC makes no representation that the recommendations of Service2Client LLC will achieve any result. The NSAD has not reviewed any of the Service2Client LLC content. Readers are encouraged to contact their CPA regarding the topics in these articles.

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