July 2002

For many mutual fund investors, the Morningstar Rating^TM for funds (commonly known as the "star rating") has become synonymous with a thumbs-up movie review. Just as a rave review can get moviegoers flocking to the theater, a four- or five-star fund rating can attract waves of new investors and investment dollars.

Since Chicago-based Morningstar, Inc. introduced its star system in 1985, however, the fund industry has experienced tremendous change. The number of funds has soared from 1,528 in 1985 to 8,307 last year, according to the Investment Company Institute. At the same time, fund companies and investors have grown more sophisticated. While many investors owned a single stock fund a decade ago, today’s stockholders may own separate funds representing domestic and international stocks, large- and small-company stocks, growth and value stocks.

To better reflect the new realities of fund investing, Morningstar recently introduced extensive changes to its star ratings, effective June 30, 2002. "Star ratings were fine when they were first created," said Russel Kinnel, director of fund analysis for Morningstar. "But as investing became more specialized, the ratings began to represent movements in the market instead of a manager’s ability to deliver attractive risk-adjusted returns."

What’s changed: 48 fund categories vs. 4

Under the old system, funds were graded within four broad asset class categories: U.S. stocks, international stocks, taxable bonds, and tax-exempt municipal bonds. With the new system, funds are slotted into one of 48 narrowly defined categories that reflect the many subtle differences within broad asset classes.

What it means: No more “apples-to-oranges” comparisons

Previously, Morningstar ratings grouped vastly different funds with different investment orientations and portfolio holdings into the same category. Within the U.S. stock category, for example, you would find large-cap value funds being measured against small-cap growth funds, technology funds, and other funds with little in common. This arrangement made it difficult for investors to perform apples-to-apples comparisons and caused many funds to receive high star ratings for reasons unrelated to the skills of their managers.

“When based on broad categories, high star ratings were often clustered in one investment style and low star ratings in another,” said Kinnel. “It didn’t mean you had geniuses managing funds in one area of the market and incompetents in another. It was simply that one style had performed better than the other.”

For example, a high yield bond fund’s rating under the old system would have been two stars, due to high yield’s relative underperformance versus other taxable fixed income styles, such as short-term U.S. government bonds. If the new system had been in place, however, this same fund would have earned four stars when compared only against its high yield brethren.

In addition to judging funds on a more level playing field, the new star ratings can also help investors build and maintain diversified portfolios. In the past, buying only four- and five-star funds often meant overweighing your portfolio in those investment styles most in fashion at the time. Now, it can mean spreading your investment dollars across highly rated funds in different categories that have performed well at different times.

What’s changed: New risk measurement

Star ratings continue to reflect risk-adjusted performance, but Morningstar has changed the way it defines risk. Using the old definition, risk was measured by a fund’s average underperformance compared to a 90-day Treasury bill. If a fund’s return exceeded this benchmark each month, it was considered risk-free. “The old rating system didn’t account for the volatility of fund returns from month to month, which is important to investors,” said William Belden, vice president of product management for Northern Trust. For example, many technology funds scored well on Morningstar’s risk scale in the late-1990s, even though they proved to be quite volatile and unpredictable.

In response, Morningstar developed a new risk measure that focuses on the amount of variation in a fund’s monthly returns. It rewards consistent performance and punishes downward fluctuations.

What it means: “Funds you can live with”

This change makes it more difficult for high-risk funds to earn favorable star ratings, according to Kinnel. “The new risk measurement reflects the notion that investors are risk-averse and want funds they can live with for the long term,” he said. “Investors tend to hold moderate-risk funds long enough to enjoy the benefits of their long-term returns. High-risk funds can produce losses that are too much to stomach, so investors tend to sell at the bottom and buy near the top.”

What’s staying the same: Still grading on a curve

As in the past, Morningstar will continue to provide monthly star ratings for funds with at least three years of performance history. Ratings are calculated for three-, five-, and 10-year periods and then combined for an overall rating. Historical ratings will not change under the new system, and funds are still graded on a curve, using the same one- to five-star scale:

Over the short term, Kinnel believes the re-categorization of funds could help areas that previously lacked five-star performers, such as large-cap growth. When these funds are regrouped into their new, more defined categories, the top 10% will earn five stars, even if they were three- or four-star recipients under the old, broader system. “Over the long term, the new ratings may be most beneficial to funds that are more risk-conscious and employ more risk controls,” said Kinnel.

Using the star ratings

Morningstar ratings were never intended to be the only yardstick used to measure fund performance. Whether you’re following the old system or the new, a star rating alone is not enough to justify buying or selling a fund. Instead, it can be part of a larger, three-step process for evaluating and selecting investments:

• Step 1: Create a plan.
  Work with an investment representative to tailor an investment plan around your unique needs. An important part of this plan is determining the proper mix of funds for your objectives, time frames, and risk tolerance.

   

• Step 2: Screen funds.
  Here’s where the star system can help to screen out high-risk or low-return funds and simplify the decision-making process. Suppose, for instance, you’re looking to add a health care fund to your portfolio. By isolating five-star, no-load funds with tenured managers, you may be able to narrow down dozens of available choices to a manageable handful.

   

• Step 3: Conduct further research.
  After you’ve identified your short list of potential funds, it’s time for you and your investment representative to dig deeper. What is the fund’s track record and asset size? Who is the manager? What are the expenses? These are the questions that can only be answered through careful analysis of a fund’s return history, fee structure, and portfolio holdings.

For more information, visit Funds and Performance or call the Northern Funds Center at 800/595-9111.