What it means
Morningstar is an investment research company, and its risk rating is one of the best-known ways of summarising a fund's risk in a single word. The rating looks at how much a fund's returns have dipped over past periods, with more weight given to the bad months than the good ones.
That focus on losses reflects the fact that most investors worry more about falling than about rising. The rating is relative, not absolute.
A fund is compared with others in the same category, such as large company shares or short-term bonds, so a bond fund rated high risk is not necessarily riskier than an average shares fund. That is why you should always read the rating together with the category it belongs to.
Ratings are usually calculated over several time periods, such as three, five and ten years, and then combined into an overall rating. Newer funds without enough history may not receive a rating at all.
Because the rating relies on past returns, it describes what has happened and is not a prediction of what will happen. For a finance team or an individual investor, the rating is a fast filter.
It can show if a fund in the portfolio is far more volatile than its peers, or whether a new option fits an investment policy that limits risk. It does not replace reading the fund's holdings, costs and objectives.
The rating also pairs naturally with a return-based rating. Looking at risk alongside return helps you see whether extra volatility was rewarded, which matters because a high-risk fund that delivered poor returns is a worse choice than a high-risk fund that delivered strong ones.
A practical way to use the rating is to set a ceiling inside an investment policy. For example, a committee might agree that no single holding may be rated above average risk without written approval.
That turns a label into a control that can be checked quickly each quarter, and it gives the committee an objective reason to ask questions when a fund drifts.
In practice
Real-world examples.
Example
A retired couple wants steady returns and sees that a growth fund carries an above average risk rating compared with other funds in its category. They decide a lower-rated fund fits better with their need to draw income. The rating prompts a conversation with their adviser before they invest, and the adviser documents the decision in the client file.
Example
A company treasurer reviewing a money market style fund notices its rating is low compared with peers. This fits the company's policy that surplus cash should be kept in low-volatility holdings. The treasurer records the rating in the investment committee papers and sets a reminder to check it again at the next quarterly review.
Example
A young professional compares two shares funds in the same category. One has an average rating and the other a high one, and the higher rated fund has not produced noticeably better returns. She chooses the average one because it offers similar returns with less risk.
Case study
Seen in the real world.
Larkspur Foundation is an illustrative, fictional charity with a $5,000,000 endowment and a policy that its portfolio should carry no more than average risk. The finance officer reviewed its eight holdings against published risk ratings.
Six funds were rated average or below, but two were rated above average. Together they made up 30% of the portfolio, which was $1,500,000 of the endowment, so the officer raised the matter with the trustees.
After discussion, the trustees moved half of the two funds into lower-rated alternatives and documented why the remaining holding was kept. The illustrative lesson is that a simple rating can trigger a useful review, as long as it is followed by a look at what is actually inside each fund.
Watch out
Common mistakes.
- Comparing the ratings of funds from different categories, when the rating only compares a fund with others in its own category.
- Treating a low risk rating as a guarantee against loss, when even low-rated funds can fall in value.
- Assuming the rating predicts the future, when it is based on past returns that may not repeat in a different market environment.
Questions
People also ask.
Is a high risk rating bad?
Not necessarily, because a high rating simply means larger past losses than peers, and some investors accept that in pursuit of higher returns.
How often does the rating change?
It is updated regularly as new return data arrives, so a fund's rating can move up or down over time.
Does the rating account for fees?
Fees affect the returns that the rating is based on, but the rating itself describes the variability of results rather than the cost of owning the fund.
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