What Is the Morningstar Risk Rating?

The Morningstar risk rating, or simply Morningstar rating, is a ranking given to publicly traded mutual funds and exchange traded funds (ETFs) by the investment research firm Morningstar. Risk is assessed across five levels designed to help investors quickly identify funds to consider for their portfolios.

Funds receive ratings ranging from 1 to 5, with 1 given to the worst performers and 5 for the best. The ranking is based on variations in a fund's monthly returns—with an emphasis on downside variations—as compared to similar funds.

Key Takeaways

  • The Morningstar risk rating is a ranking given by research firm Morningstar to publicly traded mutual funds and exchange traded funds (ETFs).
  • A score of 5 is given to the best risk performers, with a 1 to the worst.
  • Morningstar ratings are based on the fund's historical performance compared to other like funds.
  • Critics argue that Morningstar ratings don't look at the bigger picture where the funds are compared to the marketplace.
  • Morningstar also provides category and peer-group ratings.

Understanding the Morningstar Risk Rating

Morningstar ratings are based on the fund's past performance as compared to other funds in its Morningstar category. The risk rating is frequently a starting point for additional research and is not a buy or sell recommendation.

In the risk rating process, 10% of a category's funds with the lowest measured risk are rated as "low risk." The next 22.5% are rated "below average," the middle 35% are "average," the next 22.5% "above average," while the top 10% are rated as "high" risk. Morningstar measures risk for as many as three periods (three, five, and 10 years). These separate measures are then weighted and averaged to produce an overall measure for the fund. Funds with less than three years of performance history are not rated.

Morningstar also provides category ratings and peer-group ratings to help investors further compare funds. For example, as of year-end 2018, Morningstar assigns a 3.9-star rating to municipal bond funds as a group, a 3.4-star rating to domestic stock funds, and a 3-star rating to international stock funds.

Morningstar rates individual mutual funds and ETFs and sells the ratings along with other research to investors.

Other Risk Rating Providers

Morningstar is not the only company that creates risk ratings. Other rating creators include Thomson Reuters Lipper, Zacks Investment Research, Standard and Poor's, and TheStreet.

Business and finance publications such as Forbes and U.S. News & World Report also rank and rate funds, as well as other asset classes, for their readers. In many cases, they base much of their analyses 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.

Example of Morningstar Risk Ratings

To get an idea of how Morningstar assigns its risk ratings, let's look at its data on the iShares Nasdaq Biotechnology ETF (IBB). The exchange traded fund is rated as presenting investors with an above-average risk rating of three stars on a three-, five- and 10-year basis, based on a weighted average of the performance figures. Over the past 10 years, the fund has delivered an annualized total return of 15.38%, compared to 11.59% for the benchmark S&P 500 index. 

How Do Morningstar’s Star Risk Rating Work?

The star rating is a quantitative metric that indicates a mutual fund's historical risk-adjusted return. Funds can receive between 1 and 5 stars, with 5 being the best. A fund loses points for having a greater "risk penalty," so if two funds return the same yield in a given period, the fund that experienced greater volatility (variance) in returns would be rated lower, as riskier.

What Does a Morningstar Risk Rating of 5 Stars Mean?

A 5-star risk rating indicates that a fund has been among the market's top performers in terms of risk-adjusted return over the past three, five, or ten-year period.

How Reliable Are Morningstar Ratings?

While star ratings provide an easy heuristic for measuring risk-adjusted return in the past, they tend to be relatively poor predictors of future performance. A research study by Vanguard found that Morningstar ratings did not predict a profitable investment relative to a fund's benchmark. Moreover, the study found that one-star funds had the greatest excess returns of all compared to their benchmarks.