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Morningstar Ratings (Star Ratings) and Their Limitations

You may have seen the Morningstar Rating (also known as Star Ratings) table in various publications over the years. The ratings consist of an easily-identifiable five-star scale, designed to assist you with investment decision-making on funds and fund managers. This article walks you through what the star rating is, what it tells you, and what it doesn't, as well as the specific parts that make up a Morningstar managed funds report.

While a higher star rating reflects stronger performance, a high star rating isn't a guarantee that a fund will be a solid performer. A fund may very well have a five-star rating because of its impressive historical record, but as performance-chasers often find out the hard way, the past doesn't reliably predict future returns. This is not to say the star rating doesn't serve as a valuable tool for investors, but it shouldn't be the only consideration. Investing in a highly-rated fund is better than investing in the latest 'hot' fund, but like any measure, the star rating has both virtues and limitations. It's important to be aware of these.

How does it work?

The Morningstar Rating for funds is a measure of a fund's risk-adjusted return relative to similar funds. Funds are rated from one to five stars, with the best performers receiving five stars, and the worst receiving a single star.

Morningstar adjusts for risk by calculating a risk penalty for each fund, based on 'expected utility' theory - a commonly-used method of economic analysis. The theory assumes that investors are more concerned about a possible poor outcome than an unexpectedly good one, and are therefore willing to give up a small portion of an investment's expected return, in exchange for greater certainty.

Consider a simple example - a fund expected to return 10 percent each year. Though investors are likely to receive 10 percent, past variations in the fund's returns suggest that they might end up with anywhere from five to 15 percent. While receiving more than 15 percent would be a pleasant surprise, most investors are more likely to worry about the downside - receiving less than 10 percent. So they're probably willing to settle for a slightly lower return - say nine percent - if they could be more certain of receiving that amount of return.

This concept forms the basis of how Morningstar adjusts for risk. A 'risk penalty' is subtracted from each fund's total return, based on the variation in the fund's month-to-month return, with an emphasis on downward variation. The greater the variation, the higher the risk penalty. If two funds have the same return, the one with more variation in its return is given the greater risk penalty. Funds are ranked within their categories according to their risk-adjusted returns, after accounting for ongoing fees and expenses. Stars are then assigned as follows:


Morningstar Ratings


To determine a fund's star rating, the fund's Morningstar Risk score is subtracted from the Morningstar Return score. The resulting number is plotted along a bell curve to determine the fund's Morningstar Rating.If the fund scores in the top 10% of its category, it receives five stars; if the fund falls in the next 22.5%, it receives four stars; a place in the middle 35.0% receives three stars; those funds in the next 22.5% get two stars; and a fund in the bottom 10% gets one star.

What it tells you

With more than 10,000 managed funds to choose from in Australia, the star rating serves as a reasonable way to narrow the universe down to a subset of funds with strong records of performance. The methodology behind the star rating accounts for variations in a fund's monthly performance, with an emphasis on recognising and penalising downward variations. A minimum three-year time period, for example, reduces the possibility of strong short-term performance influencing the rating.

By comparing funds with their closest competitors, investors can focus on the top performers within a given category, without concern over whether the rating is penalising funds for sticking to an out-of-favour style. All categories, from small-growth to large-value, fall out of market favour from time to time.

What it doesn't tell you

A measure that takes long-term returns and risk into account is a good first step in a search for 'best-of-breed' managed funds. The key words, though, are first step. While the star rating is a quick and easy way to get a feel for a fund's historical performance, it does not capture - nor was it designed to capture - all the factors that will contribute to a fund's future returns.

The star rating is a strictly quantitative measure - it doesn't include any input from Morningstar fund analysts about the people who are running the fund, or the investment processes and styles used.

The star rating doesn't take fundamentals into account - what makes a fund tick.

Important: Because funds are rated within their respective Morningstar categories, not all five-star funds are interchangeable or equal. For example, a five-star sector-based fund, such as an emerging markets international equities fund, may have the best risk-adjusted return compared with similar funds within a particular Morningstar category, but it may be riskier than an established, diversified international equities fund.

Qualitative research - Morningstar Fund Analyst Ratings

The purpose of Morningstar qualitative research - analyst research reports - is to determine which fund managers deserve the attention of investors and which do not. Morningstar assesses fund managers on the basis of how they are perceived to perform in the future over an economic cycle, against both peers and accepted benchmarks. The Morningstar model rewards managers which are open and transparent, have a well-run investment process, and most importantly, are good fiduciaries of investors' monies.

Morningstar qualitative research assesses a fund manager's capacity in an asset class in five key areas: the investment people, the investment philosophy and process, the composition of the investment portfolio and how it reflects the process, the fund manager's parent and the performance track record. The portfolio and performance are considered key outcomes of the investment process.

Morningstar Fund Analyst Ratings

The Morningstar Fund Analyst Rating signals the extent to which the strategy is recommended for inclusion in your portfolio, the standouts in each asset class, the funds which should be avoided, and those in between. The five-point Morningstar Fund Analyst Ratings scale is "Gold", "Silver", "Bronze", "Neutral" or "Negative".

Fund analysts determine Morningstar Fund Analyst Ratings by considering the process they use, the people running the strategy, and issues relating to the business/parent. A number of characteristics can have positive or negative effects on the overall qualitative assessment, including any portfolio size and capacity issues; the extent to which the investment style used is clearly-differentiated or one of many; the role of the strategy in an investor's portfolio; the impact of costs including any performance-based fees; and any governance issues or concerns.

How we decide on a Fund Analyst Rating

Morningstar Fund Analyst Ratings are decided by considerable and open debate within Morningstar's fund analyst team. Recommendations are based on the key issues of people, process, and the parent. A number of other issues are also taken into account, including a relative ranking of similar investment styles and approaches.

To determine the Morningstar Fund Analyst Rating, an initial recommendation is put forward by the primary fund analyst. This recommendation is then discussed extensively within the fund analyst team and an overall view is formed. Morningstar Fund Analyst Ratings are discussed with Morningstar's global fund analyst teams. The Morningstar Fund Analyst Rating is the final outcome of a collaborative process based on a site visit, analyst questionnaire, quantitative and holdings-based analyses of the portfolio, and an assessment of all the key issues outlined. This is illustrated in the diagram below.





Morningstar assesses the investment philosophy and process, research drivers, and construction and implementation of the portfolio.

Key questions asked are:

  • Is there a clearly-articulated investment philosophy and a process discipline?
  • How does the process work in practice?
  • How is research performed?
  • What are the key drivers, and how is it different to competitors?
  • Is the research effort logically consistent with the stated investment process?

Morningstar also considers whether the construction and management of the portfolio reflects the process, and uses holdings-based analysis in order to gain insights into the key portfolio characteristics both current and past.

Role in Portfolio

'Role in Portfolio' tells you whether the flagship fund is Core, a Supporting Player, or Satellite holding within the sector under review, and whether you need to blend the strategy with other investment styles and strategies. This is a guide only, and is not a recommendation to invest.


Morningstar assesses the key individuals making the investment decisions, as well as the composition of the investment team, including:

  • Is there a clearly-articulated investment philosophy and a process discipline?
  • relative size and resources;
  • experience levels and the mix and balance of skills within the overall team skillset;
  • the degree of team stability;
  • team members' familiarity with and ability to articulate the promoted investment philosophy and strategies; and
  • any key person risks.

In short, how good is the team, and how does it stack up against its peers?


Morningstar does not explicitly rate Performance, which is captured in our Morningstar Rating. Instead, the key drivers of past performance and how they relate to the investment process and philosophy are explored. What has the fund manager got right or wrong, and why? How is the portfolio positioned currently, and why?


Morningstar assesses the fund manager's parent and/or ownership structure, including organisational and ownership stability. Morningstar focuses on one key parentage issue: is the fund manager likely to be a good steward of investors' money? The types of products and fees, the investment and corporate culture, back office functions, transparency, and tax awareness are among the key factors considered.

Morningstar qualitative research gives you everything you need to make a comprehensive assessment of whether an asset class strategy deserves a place in your portfolio. You should come away with a clear understanding of the key issues associated with the strategy, and whether or not it suits your needs. We recommend you read the full research report before making any decisions.