What You Need to Know about Mutual Fund Ratings

Mutual fund investors need to understand ratings to make better judgements about mutual funds they're looking to buy.

Mutual funds, although easy to invest in, can be tricky investment given their vast variety and different fund managers’ skills. Many mutual fund investors rely on Morningstar ratings where funds are rated from one star (bottom 10%) to five stars (top 10%). While it definitely shows who has performed better, the star rating is based on past performance and isn’t the greatest indicator of the future performance of the fund. In fact, many Morningstar Five-Star funds did well because the sector they invest in had a bull run.

Great performance may, indeed, indicate that the sector is overpriced and about to enter a correction. Many outperforming mutual funds who were given Five-Star ratings, and subsequently attracted major contributions, in the following years became underperformers. What then is the use for the star rating? One thing is for sure: One-Star rating may indicate weak management performance, and with so many funds to choose from, it may be better to avoid these funds. Meanwhile, funds with two stars are considered to be underperformers, Three-Star funds to be the average ones, and Four-Star mutual funds are above average performers, with five being the best.

Morningstar ratings performances, as many of the other ratings, have met with criticism as, many claimed, the star ratings do not help greatly when it comes to determining fund’s future performance. In response, Morningstar has introduced another rating on top of the stars. The additional ratings introduce a scale which consists of gold, silver, bronze, neutral, and negative scores. These are analyst expectations as to how well the mutual funds will perform in the longer term. Gold, of course, is the best score.

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