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This is the ranking that is given by Morningstar, an investment firm, to mutual funds and Exchange-Traded Funds (ETFs) that trade publicly. The Morningstar Ratings are also known as star ratings, ranging from one to five where five is the best and one denotes the poorest rank. The rating helps investors in identifying funds for their portfolios.
Morningstar rating is a mutual fund ranking system which involves the use of quantitative measures to gauge the risk-adjusted performance of funds. These funds could be evaluated over a period of three or five or a ten year period with regards to the performance of funds that are similar to it or grouped in the same category. The ratings are then assigned between one and five, with five being the highest rating.
Morningstar incorporates the use of objective tools of mathematical nature for three-time durations: three years, five years and 10 years. An overall rating for the fund is created by combining the rating of each of these three funds’ time periods. It is important to note that Morningstar does not take those funds into consideration that have a history of fewer than three years. The agency also rates individual funds and then sells the research findings to investors. To help investors with a further comparison of funds, Morningstar also offers ratings pertaining to categories and peer-groups.
The Morningstar ratings are an entirely mathematical method of rating and highlight how a fund’s performance and returns over the past years have benefitted the shareholders for the risk they have taken on the same. There are no inputs, subjectively, in the ratings and the star ratings are not assigned by the Morningstar fund analysts. The addition or subtraction of stars does not happen as per the liking or popularity of funds. As per the performance of the funds, 5 stars for the best performers and 1 star for the worst performing funds, is how Morningstar rating takes place. Morningstar measures a fund’s risk level by taking into account a risk penalty for each of the funds. This is based on “expected utility theory” which is a very common method of economic analysis. It is based on the assumption that investors concern themselves more with a possible poor result than a surprisingly good outcome. These investors, according to the assumption, are ones who are willing to part with a small fraction of an investment’s expected return for a higher certainty.
If you take a simple example, where a fund has an expected return of 10 percent, annually, it is most likely that the investors will receive 10 percent. But if the past returns indicate that it is possible the investors may get anything between 5 percent to 15 percent on that fund, chances are investors will be more concerned about receiving less than 10 percent than being optimistic about receiving more than 10 percent. Therefore, these investor’s show a higher possibility of settling for a lower return of say 8 or 9 percent if they are more certain of receiving this amount. Similarly, if a fund has an expected return of 10 percent annually, with variation in returns in the past ranging between 8 percent to 12 percent, investor’s will be willing to let go of a bit of their expected return if they feel they have a higher certainty of getting a slightly smaller amount.
This is how Morningstar makes adjustments for risk. Morningstar subtracts a risk penalty from each fund’s total return on the basis of variation in the past month on monthly returns during the rating period, with a certain emphasis on the variation heading downwards. This penalty is based on the extent of the variation – the more the variation, the greater the penalty. In case of a scenario where two funds have the same return, Morningstar assigns a larger risk penalty to the fund with more variation in its return. According to their risk-adjusted return, the funds are then ranked within their categories. This is done by taking into account the sales charges and expenses.
The 10 percent funds in every category having the highest risk-adjusted return are assigned 5 stars. The next 22 percent of funds in each category are given 4 stars while the 35 percent in the middle are allotted 3 stars. The second from bottom, which is 22 percent of funds, receive 2 stars. The bottom-most 10 percent funds receive 1 star. In case of multi-share-class funds, the rating for each share class is done separately and counts as a portion of a fund that is on this scale. This can cause a little variation in the percentages of distribution. This accounting measure prohibits a single portfolio that has multiple share classes in much smaller categories from dominating any fraction of the rating scale.
Morningstar recalculates the ratings each month for funds that are rated for three, five and 10 years. Of course, funds that do not have a performance history of at least three years are not rated. The rating for a fund that has only three years of performance history, Morningstar gives them the same star rating as their overall rating. The five-year history of those funds is taken into account that has a five-year record. Their histories will account for 60 percent of their overall rating and 40 percent will depend on their three-year rating. For those funds that have more than 10 years of performance history, Morningstar considers 50 percent from the 10-year rating, 30 percent for their five-year rating and 20 percent for their three-year rating.
During the evaluation period, if a fund changes its Morningstar category, there is less emphasis on its historical performance in the other category, depending on the extent of the change. If a fund moves from a small cap category to a large-cap category, it is given more weight than if the move was from a mid-cap category to a large-cap category. This way Morningstar makes sure that there is a fair comparison and also minimizes the prospects of any incentive for fund companies that seek to change their fund’s category just to get a better rating. Though the ranking system established by Morningstar takes into account the risk-adjusted performance of funds backed by quantitative measures, if you are a new investor you must consult a financial expert before investing in mutual funds. Visit Cleartax to further explore your investing options. Hence, it is important to use these ratings as a way to screen potential funds you could invest in. For more help, please do use our ClearInvest portal.