It's all relative (sometimes) when using fund ratings

Some key fund metrics measure performance within a category, but don't lose sight of the bigger picture.

Adam Zoll 18 August, 2014 | 6:00PM

Question: I noticed that one of my funds has a higher star rating than another of my holdings that has had much better returns. How can this be?

Answer: The star rating, officially known as the Morningstar Rating for funds, has a lot of moving parts. For one thing, it's a risk-adjusted measure, so a high-returning fund with a high level of volatility won't necessarily earn more stars than a lower-returning but less volatile peer. In addition, funds' star ratings are based on risk-adjusted performance over the past three-, five- and 10-year periods. If one fund has been around for 10 years but the other has only been around for five, that can skew its rating higher or lower.

Finally, it's important to note that funds' star ratings are based on their risk-adjusted returns within their categories and not on an absolute basis. That means that a fund that's a superstar within a poorly performing category can earn a 5-star rating even though its performance is worse than that of a dud fund in a strongly performing category. The idea is to give investors who already know what kind of fund they're looking for a simple tool to distinguish which funds within a category have been the best long-term performers.

As an example, a Canadian Equity fund averaging 7% annual returns over the past decade may carry a 1-star rating if its risk-adjusted performance during that time lands it among the 10% worst in its category. (For a refresher on how Morningstar calculates risk-adjusted returns and how they are used to calculate the star rating, click here.) Meanwhile, a Global Fixed Income fund that has returned 6% per year over the same time period may carry a 5-star rating because it has significantly outperformed its peers on a risk-adjusted basis, landing it the top 10% of the group. The bond fund's strong relative performance earns it a 5-star rating even though its risk-adjusted returns have been less than those of the underperforming Canadian Equity fund.

When it debuted in the United States in 1985, the star rating compared a fund's performance within one of six broadly defined asset classes. One problem with this approach was that funds that used similar strategies tended to get similar star ratings; for example, value-oriented equity funds typically earned higher star ratings than growth-oriented ones. To address this problem, and in response to investors building more diversified portfolios (as opposed to owning just a fund or two), the star rating for funds evolved into one based on a fund's performance against a more focused group of competitors, also known as its fund category. This method has been used in Canada since Morningstar's arrival in 2000, with ratings based on standard categories defined by the Canadian Investment Funds Standards Committee.

Where relative ratings are used

The star rating is just one of several Morningstar metrics based on a fund's performance relative to its peer group and which is designed to help investors identify funds that are the best of their breed. Here are some others:

Rank in Category: Found in the Performance tab of a fund's Quicktake report, this metric represents where the fund's returns fall on a percentile basis relative to its peers over various time frames. As with the star rating, a fund that ranks low relative to others in its category may still have outperformed a fund that ranks highly within a low-performing category.

Morningstar Risk: This measure of volatility, which places particular emphasis on downside movements, is based on how a fund compares to its category peers. However, just because a fund has low Morningstar Risk relative to others in its category doesn't mean it's a low-risk fund overall. As an example, a fund from a volatile sector such as energy may be less volatile than its peers and thus carry a low or below-average Morningstar Risk rating. Yet, it may still be riskier overall than a fund that carries an above-average Morningstar Risk rating in a lower-risk category, such as U.S. Equity or most bond categories. To compare funds' volatility on an absolute basis, one place to look is at standard deviation, found under the Risk/Rating tab on fund pages. Standard deviation measures the degree to which a fund's performance varies over a given period. A fund that is rather stable with little variance will have a lower standard deviation than one that is volatile. For example, the average energy sector fund has a 5-year standard deviation of more than 18 while for the average Canadian Fixed Income fund it's just 3.

Morningstar Return: This measure of a fund's return above and beyond the risk-free rate (that is, its return beyond what an investor could have gotten by owning short-term Treasury bills over the same period) is also based on the fund's performance relative to its peers. Like Morningstar Risk, it can be found on a fund's Quote page or under the Risk/Rating tab. For more on using both of these metrics, read this article.

These and other category-specific ratings are extremely useful once you've decided what type of fund you are looking for. But, of course, a fund's relative performance as compared with its peers won't tell you the whole story. Your best bet is to use them as a starting point before looking deeper.

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About Author

Adam Zoll

Adam Zoll  Adam Zoll is an assistant site editor with Morningstar.com