Looking Beyond the Stars

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What criteria do Morningstar use for rating funds? Can I trust the ratings?

QUESTION: What criteria do Morningstar use for rating funds? Do they just look at past performance or do they have forward-looking criteria, such as an evaluation of the current makeup of the portfolio and the strength of the investment team in each fund? I would appreciate some clarification because at the moment I am not sure whether I should trust Morningstar ratings.

ANSWER: While the Morningstar ratings system is trustworthy, the ratings themselves are useful only if you understand what they mean and how they're calculated. Just because a fund advertises a five-star rating from Morningstar doesn't mean that it should be in your portfolio. Unfortunately, many investors misconstrue what those stars mean, says Mari Adam, a certified financial planner in Boca Raton, Fla. They aren't like the ones given by movie reviewers or restaurant critics, because they don't reflect some sort of overall verdict on a fund, says Russ Kinnel, director of fund analysis at Morningstar. At best, the rating system can be used as a starting point for more exhaustive research.

Morningstar's ratings system measures the risk-adjusted performance of funds that have at least a three-year performance history. Each fund is evaluated on its risk, relative to its category as a whole, and on its returns, adjusted for loads calculated monthly based on data from the fund companies. Those that score in the top 10% of the curve receive five stars, the next 22.5% receive four stars, the middle 35% receive three stars and so on.

As you can see, the ratings are hardly subjective opinions. But just because they're objective doesn't mean they're the final word on funds. What the ratings provide is a good idea of how a fund performed on a risk-adjusted basis over a historical period. What they don't tell you is how the fund is doing today or how it will do in the future, says Kinnel. Consider the Berkshire Focus fund (BFOCX). In March 2001, Berkshire Focus dropped from a lofty five-star rating to three stars after the fund lost nearly 30% that month, and now it stands at a humble one-star rating. On the other hand, Pioneer High Yield A (TAHYX) was a three-star-rated fund that got a boost to five-star status in May 2001 because of strong April 2001 returns as well as historically outperforming its peers in the taxable bond category.

You should also keep in mind that the ratings are based on four broad categories: domestic stock, international stock, tax-free bond and taxable bond. Because individual funds are placed in categories that are so sweeping, high ratings usually go to funds with a style that's in favor. In 1999, for example, large-cap growth and technology funds consistently got high ratings, but small-cap value did poorly. These days, value funds are top-rated, says Adam.

What you should do instead is compare a fund against its peers in smaller categories. Compare a large-cap growth fund to other large-cap growth funds and an intermediate bond fund to other intermediate bond funds, for example. These comparisons should be used as preliminary analysis, says Bob FitzSimmons, a certified financial planner in Lincoln, Neb., who specializes in mutual funds. Your conclusion should come after taking the time to do a lot more research, he says.

What else should you know? First, you'll need to be clear on your investment objectives and the asset allocation of your overall portfolio. The fund's objectives should match yours, and it should fit in with the rest of your assets. Then examine the fund's specific characteristics, such as expenses, style, risk and management. Look back into the fund's history to see how it did over a longer term than may be reflected in the Morningstar rankings. Take note of any changes in management and try to track a new manager's previous performance. Finally, dig into the fund to see what stocks are in its portfolio. In other words, basic performance rankings are just a starting place, and you have to look beyond them before making an investment decision.