Morningstar Ratings — Are They Meaningful?

One of the resources that many investors turn to when evaluating funds is Morningstar. Morningstar has built an entire business on rating funds, using the famous five-star system that many of us are familiar with. But, while funds like to tout their ratings and investors rely on them to determine what constitutes a “good” fund, these ratings may not be terribly meaningful.

How Does Morningstar Figure Its Ratings?

Funds with a three year history all have ratings ranging from one star (lowest) to five stars (highest). In order to determine its star ratings, Morningstar looks at risk-adjusted trailing performance. As part of the formula, Morningstar does include costs, considering returns that come after fees are deducted. However, the fact that past performance is a huge part of Morningstar’s rating system means that there is a big problem with how meaningful the ratings actually are.

Past Performance and Future Results

Investors are familiar with this common chant: “Past performance does not guarantee future results.” This means that it becomes necessary to ask yourself how meaningful a star rating system based on what has happened in the past is. If past performance can’t be taken as an indicator of future results, Morningstar ratings based on these performances might not be as meaningful as expected.

It is true that past performance can provide clues about a company, and its likely health. From that standpoint, looking into the past isn’t a bad idea. But relying heavily on Morningstar ratings to help you choose a fund that will perform in the future might not be in the best interest of your investment portfolio.

Could Expense Ratios Be More Meaningful?

Instead of relying on Morningstar ratings, you might actually be better off checking into expense ratios. In 2010, Russel Kinnel, Morningstar Director of Research, actually addressed the issue of star ratings vs. expense ratios (you need a Morningstar free membership to read it). He basically hedged on the usefulness of the ratings from Morningstar, and pointed out that expense ratios offer a better gauge of how a fund is likely to perform in the future.

The problem is that many funds, especially index funds, are going to deliver average returns when compared to the market. A lower cost fund, therefore, provides you with the best chance of doing well. When shopping around for a fund, therefore, you might be better off taking a look at the expense ratios, and not paying as much attention to what star rating Morningstar provided.

Bottom Line

Morningstar’s ratings can provide you with helpful information about a fund, and can be one of the tools that you use when considering where to put your money. However, it’s a mistake to put too much faith in Morningstar ratings. They are not as meaningful as Morningstar — and the funds that tout their four and five star ratings — would have us believe.

Use Morningstar ratings as one indicator in selecting a fund. Don’t forget to look for other variables, including expense ratios, fund management, underlying investing methods, and economic factors. Not withstanding, Morningstar’s premium membership is still very useful. It has a 10-year performance history and many tools that can be used in aiding your investment decsions.