Should you worry if your mutual fund never receives a top rating from Morningstar?

Some investors may start to doubt their mutual fund choice if their fund doesn't receive a top rating from Morningstar. Should they?

As you might know, Morningstar rates funds based on performance over the last three, five and ten years on a scale ranging from one-star (lowest) to five-star (highest). Ratings are assigned on a curve, with 10% of funds receiving five stars, 22.5% receiving four stars, 35% receiving three stars, 22.5% receiving two stars and 10%receiving one star.

This information can be an important part of the fund analysis process. However, some investors may want to use the number of stars a fund receives as the sole criteria for gauging a fund's performance. And that approach might not be prudent for a number of reasons.

First, not every fund has an equal chance of receiving the highest rating. Risk-adjusted returns (RAR) - on which Morningstar bases its ratings - are calculated over one of four broad categories. These include domestic equity funds, international equity funds, taxable bond funds and municipal bond funds. But in each RAR category, there are different asset classes, such as small-cap funds and large-cap funds, and at any given time one of those asset classes may be performing better than the others. As a result, funds in asset classes that are performing well at a given point in time may receive a higher rating than others

Second, ratings tend to favor newer funds in some cases. When Morningstar calculates overall ratings, ten-year statistics account for 50% of the overall score, five-year statistics account for 30%, and three-year statistics account for 20%. But if only five years of data is available, the five-year period is weighted 60% and the three-year period 40%. And if only three years of data is available, the three-year statistics alone are used in the overall rating. As a result, older funds that did not perform well in their early years but perform well now could receive fewer stars than their current performance justifies.

Finally, it may go without saying, but past performance does not guarantee future success. This years winner could be next year's loser - and vice versa. The moral of the story: although Morningstar ratings can be a very helpful tool for evaluating a fund's performance, no third-party system should take the place of the work that you and your financial advisor do to analyze your specific investment objectives.

I always advise people to consult with their own qualified legal, tax, and financial advisor prior to making any financial decisions.

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