The Morningstar Rating for funds, commonly called the star rating, is a measure of a fund's risk-adjusted return, relative to similar funds. Funds are rated from one to five stars, with the best performers receiving five stars and the worst performers receiving as single star.
Risk-adjusted return is calculated by subtracting a risk penalty from each fund total return, after accounting for all loads, sales charges, and redemption fees. The risk penalty is determined by the amount of variation in the fund's monthly return, with emphasis on downward variation. The greater the variation, the larger the penalty. Funds are ranked within their categories and stars are assigned as follows:
Top 10%: 5 stars
Next 22.5%: 4 stars
Middle 35%: 3 stars
Next 22.5%: 2 stars
Bottom 10%: 1 star
For multi-share class funds, each share class is counted as a fraction of a fund within this scale and rated separately, which may cause slight variations in the distribution percentages. This accounting prevents a single portfolio in a smaller category from dominating any portion of the rating scale.
Funds are rated for up to three periods, the trailing three-, five-, and 10-years, and ratings are recalculated each month. For funds that remain in the same Morningstar Category for the entire evaluation period, the following weights are used to calculate an overall rating:
Age of fund Overall rating
> three years , < five years 100% three-year rating
> five years, < 10 years 60% five-year rating
40% three-year rating
> 10 years 50% 10-year rating
30% five-year rating
20% three-year rating
If a fund changes Morningstar Categories, its long-term historical performance is given less weight, based on the magnitude of the change. (For example, a change from a mid-cap category to large-cap category is considered significant than a change from small-cap to large-cap.) Doing so ensures the fairest comparisons and minimizes any incentive for fund companies to change a fund's style in attempt to receive a better rating by shifting to another Morningstar Category.
For the Pros
Using the Rating
The star rating is best used as an initial screen to identify funds worthy of further research, those that have performed well on a risk-adjusted basis relative to their peers. It's a strictly quantitative measure—a high rating doesn't imply the approval or endorsement of a fund by a Morningstar analyst. Keep in mind that the rating is based on the fund's historical performance, hence a highly rated fund may no longer have the portfolio manager responsible for that performance.
Also, because funds are rated within their respective categories, it's also important to note that not all five-star funds are equal or even interchangeable. A five-star sector fund, for example, might have the best risk-adjusted return within its specific category, but it's probably far more risky than a highly rated diversified fund.
Rather than selecting funds based solely on their ratings, investors should decide on an overall portfolio strategy and then seek the best funds for each portion of their portfolio.