What is the 'Morningstar Risk Rating'

The Morningstar risk rating is a ranking given to publicly traded mutual funds and exchange-traded funds (ETF)s by the investment research firm Morningstar. The ratings range from one to five stars, with one being the poorest rank and five being the best. Morningstar's risk ratings, also called star ratings, are designed to help investors quickly identify funds to consider for their portfolios.

BREAKING DOWN 'Morningstar Risk Rating'

Debuted in 1985, Morningstar risk ratings are based on the fund's past performance, the fund manager's skill, risk- and cost-adjusted returns, and performance consistency. Morningstar assigns a one-star rating to 10% of the funds it evaluates, a two-star rating to 22.5% of funds, a three-star rating to 35% of funds, a four-star rating to 22.5% of funds. and a five-star rating to 10% of funds. The Morningstar ratings are intended to be a starting point for further research and are not buy or sell recommendations.

How Morningstar Creates Risk Ratings

Using objective mathematical tools, Morningstar evaluates funds for up to three time periods: three, five and 10 years. It combines the ratings for each of these time periods to create an overall rating for the fund. The agency does not evaluate funds with less than three years of history. The company creates ratings for individual funds, such as the American Funds Growth Fund of America, the Vanguard 500 Index Investor Fund, the American Funds Capital Income Builder and thousands of others, and it sells these ratings along with other research to investors.

Morningstar also provides category ratings and peer-group ratings to help investors further compare funds. For example, as of 2016, Morningstar assigns 3.9-star rating to municipal bonds, a 3.4-star rating to domestic stock and a 3-star rating to international stock.

Other Risk Rating Agencies

Morningstar is not the only company that creates risk ratings. Other rating creators include Thomson Reuters Lipper, Zach's Investment Research, TheStreet, and Standard and Poor's. Business and finance publications such as Forbes and US News also rank and rate funds, as well as some other investments, for their readers. In many cases, they base much of their analysis on ratings from Morningstar and the others.

Criticism of Morningstar Risk Ratings

While Morningstar ratings are considered essential in guiding investors toward quality investment decisions, they are not immune to criticism. Some financial analysts have criticized these ratings because they only compare funds to other funds, in isolation from the greater marketplace. As a result, a fund's rating may reflect its suitability for the particular market more than its overall viability and potential. For example, as prices are rising in a bull market, funds with historically safe stocks from companies such as AT&T tend to perform well. Conversely, when prices are falling in a bear market, funds featuring speculative stocks from companies such as Tesla Motors and Charles Schwab tend to do better. As a result, some investors prefer ratings that keep the market conditions in mind, such as the ratings generated by Forbes.

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