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Morningstar to Alter 'Star' System

Investing: Mutual fund ratings will be based on performance within specific categories rather than broad asset class.


Morningstar Inc. said Monday it will overhaul its 17-year-old mutual fund "star" ratings, seeking to make the widely quoted performance snapshots more useful to investors and less swayed by market tailwinds and headwinds.

Starting in July, the star ratings will be based on individual stock and bond funds' risk-adjusted performance compared with their peers in more than 40 specific fund categories, such as large-cap growth stock funds or long-term government bond funds.

Currently, a fund's performance is measured against its broad asset class, such as all U.S. stock funds or all taxable bond funds.

The star ratings (from 1 to 5, with 5 the top rating) also will put more emphasis on volatility of performance, giving an edge to consistent managers and penalizing those whose funds have been prone to major swings, Chicago-based Morningstar said.

The changes should help investors better determine whether managers are "adding value" within their specific fund categories, said Russel Kinnel, Morningstar's director of fund analysis. Managers will no longer get a boost, or be penalized, simply because their fund category has been in or out of favor in recent years, Kinnel said.

Star ratings are based on three-, five- and 10-year returns, as available; funds newer than 3 years old are not assigned stars.

Ten of the 25 biggest stock and bond funds will see their star ratings change under the new system, according to Morningstar projections. American Funds' Growth Fund of America, for example, a standout in the slumping large-cap growth category, would get 5 stars rather than the current 4; conversely, Putnam Growth & Income, which has benefited from being in the relatively unscathed large-cap value category, would be downgraded to 2 stars from 3.

The new star system will be similar to Morningstar's current "category ratings" system, which will be dropped.

Kinnel said the change won't matter much to many financial advisors and Morningstar clients who recognized the shortcomings of the old system. But he said the shift should make the star ratings more reliable for those who see them quoted in fund advertising and use them as a "quick shorthand" for finding investment ideas.

Irvine-based financial planner Victoria Collins agreed. "Anything Morningstar can do to improve the ratings will help," she said. "Knowing that people use them in a simplistic way, at least they should be as accurate as possible. The general public has come to rely on the star rating system."

Bart Francis, president of Evensky, Brown & Katz, a wealth management firm in Coral Gables, Fla., said his firm ignores the current star ratings, though "some clients use them to make a quick cut, or they may ask us why a particular manager has four stars while someone else has five." For investors who follow the ratings, "comparing funds against their peers only makes sense," Francis said.

As an example of how the star ratings landscape will change, of the 109 small-cap "value" stock funds that have a three-year track record, currently 60 get 5 stars and none gets 1 star, said Morningstar analyst Christopher Traulsen. Under the new system, the distribution will even out: At least 11 of the funds will be rated 5 stars and at least 11 will be rated 1 star (the actual numbers may vary because of multiple share classes).

Morningstar will use a bell curve to award stars: Ten percent of funds in each category will get 1 star and 10% will get 5 stars; 22.5% will get two stars and 22.5% will get four stars; 35% will get 3 stars.

The changes will almost certainly alter how some fund companies market their funds in ads or investor literature, analysts said.

Four- and 5-star funds have gotten strong net cash inflows from investors every year since 1999 and so far this year, according to Boston-based data tracker Financial Research Corp., whereas 1-, 2- and 3-star funds, as a group, have seen consistent outflows. Fund flows measure new money invested minus redemptions.

But it's unclear whether performance-chasers rely on star ratings or raw returns, Traulsen said. Funds that are too new to be rated by Morningstar also have gotten strong net cash inflows in recent years, Financial Research data show--perhaps because they have been launched in strong categories.

More information about the new ratings is available on the Web at

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