What it means
Morningstar began by collecting and publishing data on mutual funds at a time when information on them was hard to find. Over the years it expanded into research on shares, bonds and exchange-traded funds, portfolio tools and index products.
It now serves individual investors, financial advisers and large institutions. Its most famous product is the star rating for funds, which gives a fund from one to five stars based on how its past returns compare with similar funds after adjusting for risk and costs.
A higher star count means better past performance relative to peers, not a promise of future gains. Alongside the stars, the firm publishes risk ratings, analyst opinions and an assessment of company value.
For businesses, Morningstar matters in several ways. Retirement plan committees use its data to choose and monitor fund options, treasurers use it to compare cash investments, and advisers use it to build client reports.
Its category definitions also give a shared language, so people can talk about a large company growth fund and be clear about what that means. There are limits.
Ratings look backwards, funds that earn five stars often attract money just before their performance cools, and no single rating captures everything about a fund. Good practice is to treat the research as one input into a decision that also considers cost, strategy and personal goals.
Because it is a listed company itself, Morningstar earns income from subscriptions, licensing of data and asset management, among other lines. Readers who want to understand how a research provider earns its living should look at its published reports.
Finally, remember that Morningstar sits in a wider industry of data providers, index providers and rating agencies. Comparing its views with other sources, and with a fund's own reports, reduces the risk of relying on one opinion.
Doing so also builds a stronger record if a decision is later reviewed by a board or a regulator.
In practice
Real-world examples.
Example
A company's pension committee reviews the fund menu for its employees. It uses Morningstar data to list each fund's category, cost and star rating, and removes two funds that have trailed their peers for years. The committee records the review in its minutes, which shows that it followed a prudent and repeatable process if a member of the scheme later asks questions.
Example
An independent financial adviser builds a client report comparing three bond funds. She uses Morningstar's category averages to show how each fund's costs and returns compare with similar funds. The client can see at a glance why she recommends the cheapest one, and the report also lists the risk rating of each fund.
Example
A first-time investor wants to buy an index fund and is overwhelmed by choice. He filters funds by category and annual fee on a research site and narrows the list to five. He then reads the analyst notes, checks the fund's holdings and compares the annual fee of each fund before choosing the one with the lowest cost.
Case study
Seen in the real world.
Dunmore Partners is an illustrative, fictional advisory firm that managed $40,000,000 for forty families. For years it picked funds mainly on five-star ratings, and clients were pleased when the stars were high.
A compliance review found that several of its five-star picks had later slipped to three stars as their strong runs faded. The firm had effectively bought after the good performance rather than before. Over three years the chasing habit had cost clients an estimated 1.5% a year in lost returns compared with a simple low-cost index fund.
It rewrote its process to use ratings only as a first filter, then compare costs, strategy and manager tenure. The illustrative lesson is that research from a provider like Morningstar is valuable when it supports your own judgment, and risky when it replaces it. The firm also now keeps a short written note explaining why each fund was chosen, so that every holding can be defended on its merits rather than on its stars.
Watch out
Common mistakes.
- Believing a five-star fund will keep outperforming, when the rating reflects past results and top-rated funds often cool off.
- Comparing star ratings across different categories without noticing that each fund is only compared with its peers.
- Assuming that Morningstar manages the funds it rates, when it is a research provider and not the fund manager.
Questions
People also ask.
What does Morningstar do?
It collects data and publishes research and ratings on investments such as funds, shares and bonds, and it also offers investment management and data services.
How does the star rating work?
Funds are compared with others in their category after adjusting for risk and costs, and are given from one to five stars based on that past performance.
Is a star rating enough to choose a fund?
No, because it ignores your own goals, tax situation and the fund's strategy, so it should be one factor among several, alongside fees, the manager's record and how the fund fits the rest of your holdings.
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