Morningstar (Nasdaq: MORN) provides investment research and education via the internet, printed publications, and software. It also offers an array of mutual funds. It is headquartered in Chicago, Ill. and was founded in 1984.
Use of the Ratings System
The Morningstar system groups mutual funds by type and then rates them with a star system, from one to five stars. Ranking by total return performance, the bottom 10% of funds are rated one star; the next 23%, two stars; the next one-third, three stars; the next 23%, four stars; and the top 10%, five stars.
The star system is not a perfect. Funds that have a good year and do well and then fail to repeat are common. Hence, one would not want to select only five star funds. However, a low rated fund, say two stars or less, is clearly not performing as well as it should. It would be wise to avoid low rated funds unless you are convinced the situation has been corrected. The star system is more a warning system that suggests further investigation is warranted rather than a final decision tool.
Evaluating a Mutual Fund
The Morningstar site provides a wealth of information useful for evaluating mutual funds you own, ones under consideration, or ones offered in your 401(k) plan, etc.. Historical return information is provided in a consistent format. Information on standard reference funds such as the Vanguard 500 Index Fund (ticker VFINX) is readily available for comparison. You will also find information on expense ratio, 12b-1 fees, loads, and the current fund manager and term of service.
Expense ratio gets a lot of attention. You would prefer the fund with the lowest expenses other things being equal. But usually performance is far more important (you hope 20 to 30%) than expense ratio (0.5 to 1.0% typical). Hence, a fund that consistently outperforms the indexes might be worth a higher expense ratio, but don't pay extra for an underachiever.
Loads and 12b-1 fees can be important in your fund selection. They are discussed in other articles.