Morningstar Risk Rating
A position or score that is given to publicly-traded ETFs (exchange-traded funds) or mutual funds
What is the Morningstar Risk Rating?
The Morningstar risk rating, also known as the Morningstar rating or star rating, is a position or score that is given to publicly-traded ETFs (exchange-traded funds) or mutual funds.
It is given by Morningstar Inc., following quantitative research on a fund’s past performance. The ratings range from 1 to 5 (1 being the worst and 5 being the best) and are based on the differences in the monthly returns of a fund, in comparison to its peers.
To help investors and enable them to identify potential portfolio additions, Morningstar assesses risk across five different levels to produce the rating.
The star rating is a mathematical calculation that indicates just how much the past returns of a fund rewarded the investors for the level of risk they took. It also assists investors and advisors in making informed decisions when it comes to portfolio diversification.
Summary
- The Morningstar risk rating, also known as the Morningstar rating or the star rating, is a position or score that is given to publicly traded ETFs (exchange-traded funds) or mutual funds.
- To help investors and enable them to identify potential portfolio additions, Morningstar assesses risk across five different levels to produce the rating.
- The ranking of funds is performed in accordance with returns (after they have been adjusted for risk).
Who is Morningstar Inc.?
Morningstar Inc. is an international financial services firm that offers financial and investment research and investment management services. Based in Chicago, Illinois, the firm’s services include analysis and compilation of data for stocks, funds, and market data.
The firm also offers wealth management, indices, fund advisory, and financial planning services. Its product offerings also include software, wide-ranging internet lines, and some print media products for the individual investor.
A popular publication of Morningstar is its one-pager on ETFs (exchange-traded funds) and MF (mutual fund) reports. They are widely used by investors to determine the investment worthiness of about 2,000 funds and more.
How the Morningstar Risk Rating Works
The risk of a fund is assessed by computing a risk penalty for each fund, following the “expected utility theory.” The “expected utility theory” argues that investors are likely to be more worried about the possibility of a negative outcome than they are expectant of a potentially positive result. The theory also suggests that investors are willing to give up a small fraction of an anticipated return on investment to have sufficient confidence.
For example, if there was a fund that expected to return 12% per annum, its respective investors will be likely to receive 12%. However, based on past discrepancies, there is a possibility that the investors can receive returns between 6% and 17%.
The possibility of receiving a return higher than 12% will be the ideal scenario for an investor, but because there is a possibility of receiving returns lower than 12%, the investor will feel uneasy.
If a chance exists for the investor to receive a lower but certain return of 8% (for example), they will settle for that option. Investors will not be willing to sacrifice much of the expected returns in exchange for more security, and thus will be interested in narrower variations such as a fund that expects to return 12%, with past variations suggesting a return from 10% to 14%.
The above ideology is the foundation followed by Morningstar to make risk adjustments. Based on a respective fund’s variation in monthly returns at the time of rating and with the emphasis being placed on downward variation, a risk penalty is subtracted from the total return of each fund.
A larger variation will result in a larger penalty. In a case where two funds generate equivalent returns, the fund with more variation will be assigned a higher risk penalty. The ranking of funds is completed in accordance with returns (after they’ve been adjusted for risk) and categories.
Morningstar Rating Periods
Rating is completed for funds with more than three years of historical performance. If a fund has less than three years, it is not rated. A fund with only three years of historical performance will receive an overall star rating that is the same as its three-year star rating.
When looking at a fund with five years of historical performance, 60% of its overall rating and 40% of its three-year rating will count for its overall rating.
Finally, when looking at a fund with more than 10 years of historical performance, 50% of its 10-year rating, 30% of its 5-year rating, and 20% of its 3-year rating will count for its overall rating.
The image above is an example of how the rating will be displayed.
Related Readings
CFI is the official provider of the global Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful:
