The Morningstar Rating (often called the 'Star Rating') is a popular quantitative scoring system developed by the financial services firm Morningstar, Inc. that grades mutual funds and ETFs. Think of it as a school report card for a fund, but one that only looks at past exam scores. Using a simple one-to-five-star scale, the rating measures how well a fund has performed in the past compared to its peers, after adjusting for risk and costs. Funds are grouped into categories with similar investment strategies (e.g., 'U.S. Large-Cap Value Equities'), and then ranked against each other based on their historical performance over three, five, and ten-year periods. While widely used by investors to quickly screen thousands of funds, it's crucial to remember what it is—a purely backward-looking measure. It reflects past glory (or failure) but offers no guarantee or prediction about how the fund will perform in the future.
The star rating isn't just about picking the funds with the highest returns. Its methodology is a bit more nuanced, focusing on rewarding smooth, consistent performance over wild, risky rides.
The core of the Morningstar Rating is the concept of a Risk-Adjusted Return. In simple terms, Morningstar doesn't just ask, “How much money did this fund make?” It also asks, “How much volatility and risk did it take on to make that money?” The calculation, which is rooted in principles from Modern Portfolio Theory, penalizes funds for downside volatility. A fund that achieves a steady 9% annual return will likely score higher than a fund that has a rollercoaster year—soaring 30% one moment and plunging 20% the next—even if their average return is slightly higher. The goal is to identify funds that have provided better returns without giving their investors too much heartburn along the way.
The star rating is a relative ranking system, meaning funds are graded on a curve against their direct competitors. A fund doesn't earn five stars in a vacuum; it earns them by outperforming 90% of its peers. The distribution is fixed and resembles a bell curve:
This structure ensures that only a select few can achieve the top rating, making it an exclusive club.
For a disciple of Value Investing, relying on the star rating can be a dangerous trap. It emphasizes recent performance and popularity—two factors that a true value investor is trained to ignore, if not view with deep suspicion.
The legendary value investor Benjamin Graham taught that in the short term, the market is a “voting machine,” tallying up what's popular. The star rating is a perfect reflection of this voting machine. However, Graham also taught that in the long term, the market is a “weighing machine,” assessing the true Intrinsic Value of businesses. A value investor's job is to focus on the weighing machine. A 5-star rating tells you what has been popular and successful; it tells you nothing about whether the fund's holdings are currently overvalued and poised for a fall.
A high star rating often indicates that a fund's investment style has been in favor. Investors who “chase stars” by buying 5-star funds are, by definition, buying what has already performed exceptionally well. This is often the exact opposite of the value investor's mantra: buy low, sell high. It can be a recipe for buying at the peak. Academic studies and market history are filled with examples of Reversion to the Mean, where yesterday's winners become tomorrow's laggards as market cycles turn.
The star rating is purely a quantitative “what.” It doesn't tell you the “why” or the “how.”
This doesn't mean the star rating is useless. It can be a helpful tool, as long as you use it correctly and understand its severe limitations.
Ultimately, the Morningstar Rating is a tool. In the hands of an undisciplined investor, it can lead to chasing performance. In the hands of a thoughtful value investor, it can be a single, small clue in the much larger investigation of finding wonderful investments at fair prices.