There are several different mutual fund ratings systems available today with varying levels of complexity and degree of focus. Most brokerage firms provide the ability to evaluate mutual funds on their website, containing ratings along with other metrics. The question is: how should you use these metrics?
Many brokerage firms use Morningstar ratings, a system established in 1985 that has become a standard but is now being challenged by other methods. Morningstar ratings are useful to the non-professional investor because they are simple – a star rating system from the least desirable one star to the most desirable five stars. However, things are always traded off to gain simplicity. You should "look beyond the stars," so to speak.
The star system of Morningstar represents relative rankings. Three stars represent the middle performing 35% of mutual funds in any particular category. Two and four stars represent the next 22.5% of funds in either direction, with one star and five stars representing the 10% of the worst and best performing funds in that category, respectively.
The stars are assigned through calculating a risk-adjusted return that takes into account volatility and historical returns. Morningstar uses a "utility theory" risk rating, assuming that investors are more disturbed by negative outcomes than they are pleased by positive ones – favoring conservative, less volatile funds as a result.
Time is taken into account by assigning stars for the past three, five and ten year periods; these time periods are weighted to produce the final rating, with older funds weighted more heavily to past ratings. For example, for funds over ten years old, the overall rating is 50% of the ten-year, 30% of the five-year, and 20% of the three-year.
Weighting toward the past gives you a greater sense of overall stability. It also gives you no indication if things are about to go downhill in the future, or if there is any reason to suspect that may happen.
Morningstar ratings compete against analyst rating systems, with alternate, less relative scales, or outright buy/sell recommendations. Standard and Poor's, Lipper, Zacks, and Thestreet.com all offer mutual fund analysis and premium services at various levels of cost.
Generally, all ratings systems allow you to see other metrics, such as:
- Historical Returns – Either in graphical form or numerical, usually with some form of relative comparison.
- Volatility Measures – Measures of fluctuation around an average and in correlation to the overall market – such as standard deviations, means, averages, r2 correlations, and beta/alpha results (performance relative to a standard index and relative to expectations, respectively).
- Sharpe Ratio – A measure of excess returns per "unit of risk." In other words, compared to a risk-free investment, how much excess returns are you receiving for the risk you are taking?
There are other fundamental measures that will generally be available through the ratings sites, and if not, they certainly will be through the brokerage sites. For example, what kind of a load does the fund carry, or is it a no-load fund?
One of the most important things you can look at is a fund's expense ratio. Some analysts claim that picking low expense ratio funds is equal, if not superior, to using the rating systems. The simple reason is that no one can predict or control how any investment fund will perform, but it is possible to control the fees one pays.
In short, any of the ratings systems can give you a quick relative snapshot of a mutual fund, and they make for excellent screening tools. However, rather than automatically buying "five-star," "A-rated" or "strong buy" mutual funds, take some time to look at the other fundamentals – especially the load structure and expense ratio.