Contributed by: Nicholas Boguth, CFA®, CFP®
You may have seen Morningstar’s popular “star rating” at some point in your investment lifetime. Sometimes it shows up on account statements, lists of investment options, or marketing materials – but what exactly is it telling you?
A common mistake we hear is that a fund is presumed to be a “good investment” because it is a “5-star fund” at Morningstar. While the fund may be a good investment, that is not what the star rating tells us.
The star rating is simply telling us how the fund performed compared to peers in the PAST, and we know from one of the most common financial disclosures in the industry that “past performance does not guarantee future results.”
In Morningstar's own words, "It is not meant to be predictive." They do have a qualitative rating that IS meant to be predictive, but that is only available to subscribers of their service (like The Center!) Morningstar is one of our team's many resources in its investment process.
We hope this provides some clarity for when you see these ratings out in the wild. Don't fall victim to what hedge fund billionaire Ray Dalio calls "the biggest mistake in investing" by thinking that just because an investment has done well in the past, it will do well in the future.
Nicholas Boguth, CFA®, CFP® is a Portfolio Manager at Center for Financial Planning, Inc.® He performs investment research and assists with the management of client portfolios.
The information contained in this letter does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any opinions are those of Nick Boguth, CFA®, CFP®, and not necessarily those of Raymond James. Expression of opinion are as of this date and are subject to change without notice. With the Morningstar rating system, funds are ranked within their categories according to their risk-adjusted return (after accounting for all sales charges and expenses), and stars are assigned such that the distribution reflects a classic bell-shaped curve with the largest section in the center. The 10% of funds in each category with the highest risk-adjusted return receive five stars, the next 22.5% receive four stars, the middle 35% receive three stars, the next 22.5% receive two stars, and the bottom 10% receive one star. Funds are rated for up to three periods--the trailing three, five, and 10 years and ratings are recalculated each month. Funds with less than three years of performance history are not rated. For funds with only three years of performance history, their three-year star ratings will be the same as their overall star ratings. For funds with five-year records, their overall rating will be calculated based on a 60% weighting for the five-year rating and 40% for the three-year rating. For funds with more than a decade of performance, the overall rating will be weighted as 50% for the 10-year rating, 30% for the five-year rating, and 20% for the three-year rating. The star ratings are recalculated monthly. For multiple-share-class funds, each share class is rated separately and counted as a fraction of a fund within this scale, 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. If a fund changes Morningstar Categories, its historical performance for the longer time periods is given less weight, based on the magnitude of the change. (For example, a change from a small-cap category to large-cap category is considered more significant than a change from mid-cap to large-cap.) Doing so ensures the fairest comparisons and minimizes any incentive for fund companies to change a fund's style in an attempt to receive a better rating by shifting to another Morningstar Category. For more information regarding the Morningstar rating system, please go to https://www.morningstar.com/content/dam/marketing/shared/research/methodology/771945_Morningstar_Rating_for_Funds_Methodology.pdf Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Securities offered through Raymond James Financial Services, Inc., member FINRA/SIPC. Investment advisory services are offered through Raymond James Financial Services Advisors, Inc.