Understanding Morningstar mutual fund ratings

Investors need to be able to examine, on a regular basis, the performance of the wide variety of funds available in order to reallocate their portfolio timely and follow the market realities. In doing so, investors avoid unnecessary losses from possible market downturns, but also they get informed on the management philosophy of the firm they have invested in.

Majority of mutual funds available are open-end mutual funds, which means that they allow selling additional shares of the fund to new investors, who wish to invest in them. Similarly, open-end mutual funds buy back or give to investors the value of the shares they wish to sell.

Morningstar Rating

Morningstar Rating provides an up-to-date quantitative assessment of over 1,300 open-end mutual funds’ past performance, both in terms of risk and return, using a scale of one to five stars. Rating and any information about each fund are provided in the form of one-pager allowing investors to consult a short analysis of the fund by Morningstar specialists including regularly-updated holdings, valuation multiples, and performance data.

1/Classification of funds

Equity securities are primarily classified according to their market capitalization, growth, blend and style value. Then, funds are categorized according to its style/value characteristics. This enables investors to distinguish among funds that use similar investment strategies and minimizes the threat of not being in the right markets at the right time.

2/Methodology

The methodology used by Morningstar Rating ranks funds based on their Morningstar Risk-Adjusted Return (MRAR) scores, which account also for any risk adjustments, sales charges or redemption fees.

Rating is for three years, five years and ten years period. The weights used for a fund that does not change categories during the evaluation period are:

• At least three years, but less than five 100% three-year rating

• At least five years, but less than ten     60% five-year rating, 40% three-year rating

• At least ten years                                  50% 10-year rating, 30% five-year rating,

20% three-year rating

3/ Expected Utility Theory (EUT)

The whole rating system is based on the Expected Utility Theory (EUT), which holds that investors decide between risky or uncertain prospects by comparing their expected utility values. In simple terms, investors are mostly concerned with underperformance and possible losses than with an unexpectedly good outcome. Therefore, driven by risk aversion, investors are willing to sacrifice a portion of expected return in exchange for greater certainty of return. Morningstar Rating takes into consideration all variations in a fund’s monthly performance emphasizing mostly to the downward fluctuations, while rewarding consistent performance.

4/ Tax Analysis

Tax analysis is very significant in funds evaluation. Funds that generate high income or capital gains through frequent trading increase taxable income of the fund’s shareholder. Morningstar Mutual Fund includes estimates of a fund’s tax efficiency based on a “business as usual” scenario analysis of a typical investor’s income tax basket and capital gains tax rates. Morningstar Mutual Fund assumes that all income and short-term capital gain distributions are taxed at a federal tax of 39.6 percent at the time of distribution. Long-term capital gains are taxed at a 20 percent rate, while the after-tax portion is reinvested in the fund.