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Did Star Ratings Work in the Pandemic?

Morningstar Canada's Director of Investment Research, Ian Tam, finds out how the Morningstar Star Rating for funds performed this year

Ian Tam, CFA 1 December, 2020 | 4:28AM
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Ian Tam: For over 20 years Morningstar has maintained a rating system that many investors have come to know as the Star Rating for funds. Did this rating work during the coronavirus pandemic? Let's find out.

Now, the Star Rating is a look back at how a fund performed relative to its peers over time. We look at 10 years' worth of performance history and put a greater emphasis on the most recent performance. Newer funds won't receive a Star Rating until they've built up at least three years' worth of history. Morningstar accounts for fees by using the after-fee return reflecting the reality of what an investor gets in her pocket. We also adjust for risk ensuring that we don't unfairly compare super-risky funds that have high returns against more conservative funds with lower returns.

Now, let's also talk about what Star Ratings are not. There is no human input in the calculation of our Star Ratings. The rating is not a prediction of what will happen to a fund in the future. However, we'll see that they do have some staying power. The Star Rating should be a starting point for further investigation and not the only thing when you look at before buying or selling a fund.

Now that we know a little bit about the Star Rating, let's have a look at how the Star Rating worked so far this year. The data for this chart spans from February 1st to October 31st of this year and outlines the performance of different groups of funds after receiving their rating. Moreover, you'll see in the vertical axis that was displaying the funds' returns in excess of the respective peer groups. This year, 5-Star funds have outperformed 4-Star funds which have outperformed 3-Star funds, 2-Star funds and 1-Star funds, again after receiving the rating.

Now, although the Star Rating is not meant to be a predictor of future returns, that previous chart showed us that they do have some staying power, at least amongst Canadian domiciled funds and ETFs. Good-performing funds have continued to be resilient this year, while poor-performing funds continued to perform poorly. As such, the Morningstar rating for funds or our Star Rating has proven itself to be a useful tool in the wake of the coronavirus pandemic.

For Morningstar, I'm Ian Tam.

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Ian Tam, CFA  is Investment Specialist at Morningstar Canada. 

 

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The Morningstar Star Rating for Stocks is assigned based on an analyst's estimate of a stocks fair value. It is projection/opinion and not a statement of fact. Morningstar assigns star ratings based on an analyst’s estimate of a stock's fair value. Four components drive the Star Rating: (1) our assessment of the firm’s economic moat, (2) our estimate of the stock’s fair value, (3) our uncertainty around that fair value estimate and (4) the current market price. This process culminates in a single-point star rating that is updated daily. A 5-star represents a belief that the stock is a good value at its current price; a 1-star stock isn't. If our base-case assumptions are true the market price will converge on our fair value estimate over time, generally within three years. Investments in securities are subject to market and other risks. Past performance of a security may or may not be sustained in future and is no indication of future performance. For detail information about the Morningstar Star Rating for Stocks, please visit here

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