How to decode risk and return measures

Green is good, and red is bad. But what do the ratings mean?

Adam Zoll 16 May, 2014 | 6:00PM

Question: Can you please explain how the Morningstar Risk Measures chart on the fund Quote pages works?

Answer: The chart you refer to indicates how a fund compares with its peers in two key metrics: risk and return. The number of boxes (rectangles) that appear for each metric, and the colour used, indicates how the fund has performed relative to its peers based on these measures.

A high rating is good, except when it's not

Reading the chart can be a little confusing because for the first metric, Morningstar Risk, a lower rating (represented by a lower number of boxes) is better -- after all, low downside volatility, which is what the Morningstar Risk rating measures, is generally seen as a good quality in a fund. With Morningstar Return, however, a higher rating (and a greater number of boxes) is better because a fund with higher returns than its peers may be seen as more desirable.

In terms of both risk and return, funds are rated as High, Above Average, Average, Below Average or Low. A fund's overall ratings for these metrics (determined by its risk and return profile during the past three-, five- and 10-year periods) are used for the chart on the Quote page. (Ratings for each separate time period may be found under the Risk/Rating tab.)

Whether a fund rates a High, Low or somewhere in between depends on how it has performed relative to its peers in these areas. Those with an overall Morningstar Risk rating among the best 10% of their category get a Low rating, while those in the next 22.5% are rated as Below Average. Those in the middle 35% are rated as Average, those in the next 22.5% are rated as Above Average, and the worst 10% of performers are rated as High.

For Morningstar Return the distribution of ratings is essentially reversed, with funds in the top 10% of their categories (with the highest returns) rated as High, the next 22.5% as Above Average, the middle 35% as Average, the next 22.5% as Below Average and the bottom 10% as Low. The chart also shows the number of funds in the category in parentheses.

The chart uses colour differently depending on the metric. In a nutshell, green boxes represent better-than-average performance while red boxes represent a worse-than-average record, even if the number of boxes varies depending on the type of rating. For example, for Morningstar Risk, in which a lower rating is better, the top rating (Low) is represented by a single green box, the next rating (Below Average) by two light green boxes, the third (Average) by three grey boxes, the fourth (Above Average) by four light red boxes, and the fifth (High) by five red boxes. For Morningstar Return, in which a higher rating is preferred, this color scheme is reversed, with four- and five-box ratings (Above Average and High) using light green and green, respectively, and one- and two-box ratings (Low and Below Average) using red and light red, respectively.

Below are two charts. The first is for a fund with a Morningstar Risk rating of Low and a Morningstar Return rating of High. The second also has a risk rating of High but has a Low return rating.

Inside the ratings

Now that you know how to read the chart, you may be wondering what these ratings mean. Let's talk about Morningstar Return first because that metric is used to calculate Morningstar Risk.

Morningstar Return is similar to Morningstar Risk-Adjusted Return, the metric used to determine the Morningstar Rating for Funds, also known as a fund's star rating. Both metrics are based on the fund's return beyond the risk-free rate -- that is, the extra performance provided by the fund beyond what investors could have gotten by investing the same amount in a very low-risk investment: short-term Canadian Treasury bills. The only difference is that Morningstar Risk-Adjusted Return adds in an extra adjustment for loss aversion, or the fact that investors generally care even more about not losing money than they do about making it.

The Morningstar Risk rating is calculated by taking the fund's Morningstar Return and subtracting its Morningstar Risk-Adjusted Return. The higher the difference between these two metrics, the higher the degree of risk taken on by the fund. Once this score is determined it is compared with that of other funds in the category to see how a given fund compares.

Because they use slightly different methods, a fund's star rating and its Morningstar Return rating won't always sync up. The star rating is a great way to see how a fund has performed on a risk-adjusted basis in the past, but it doesn't give you a complete picture. By also looking at the fund's Morningstar Risk rating, investors can get a sense of the fund's downside volatility while the Morningstar Return rating provides a more straightforward, non-risk-adjusted look at fund performance.

For example, RBC O'Shaughnessy U.S. Value   is a 4-star U.S. Equity fund with High ratings for risk and return, suggesting that its path to strong performance has been more volatile than that of one of its competitors, Beutel Goodman American Equity, which carries 5 stars and an High Morningstar Return rating but a Below Average Morningstar Risk rating. Of course, low risk is no guarantee of good overall performance, as shown by Scotia U.S. Blue Chip, a 1-star U.S. Equity fund with a Below Average risk rating and Low return rating.

The lesson, as always, is not to rely too heavily on any one fund metric, but rather to use metrics in concert to arrive at a clearer picture of how a fund has performed in the past. Even so, past performance is no guarantee of future performance. It merely serves as a guide to more informed decision-making.

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About Author

Adam Zoll

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