Understanding Morningstar

For many investors, especially those looking for diversification in their retirement plans, mutual funds have become the investment vehicle of choice. Exposure to different asset classes, diversification among those asset classes, and the ability for fund managers to actively seek returns on investors' behalf makes for an attractive investment choice. Morningstar, an investment research firm in Chicago, has become a leader in mutual fund research. It provides data, analysis, and ratings on most of the mutual funds available. But because the analysis is so comprehensive, it can be difficult to digest each piece of data. Here are a few of the less understood data pieces explained.

Morningstar Rating (for Funds)

Morningstar offers a rating for all of the mutual funds it covers. This piece of data is based on the return of the funds and works to indicate how well (or poorly) the fund has performed as compared to its competitors within the same category. Within these categories, Morningstar adjusts the performance of each fund for things like sales charges and risk to provide an apples-to-apples comparison that investors can easily absorb. The more stars, the better the performance. Funds that find themselves in the top 10% of performance in their respective categories receive 5 stars, while the bottom 10% of the funds earn only 1 star. This rating is applied to 3, 5, and 10 year periods and an overall rating is produced by combining these ratings. Though this piece of data should not be looked at as a buy or sell signal, it is very useful in quickly ascertaining the past performance of a particular fund.


When considering performance, it is important to understand the "why" of a historical return. In order to judge the performance, investors should understand how both a fund's competitors and its benchmark have performed over the same period. Investors also should consider how closely a fund mirrors its benchmark as this can work to demonstrate its usefulness in providing the desired exposure to a particular market segment. One way to get a handle on this relationship between the fund and its benchmark is "R-squared." This is NOT a performance number, but rather an interpretation of the correlation between the portfolio and its benchmark. This number ranges from 0 to 100. The higher the number, the greater the correlation between the portfolio and the benchmark. Understanding this number can give an investor an idea of how much of the fund performance is derived from movements in the benchmark.

Turnover Ratio

To get a handle on how actively a fund is managed, or how often the fund trades, investors considering a fund should look at its Turnover Ratio. This ratio measures the trading activity and is computed by taking the lesser of dollars purchased or dollars sold and dividing that number by the average net assets each month. Investors can look at this figure as a percentage of the portfolio's holdings that have changed over the last year. This is useful when trying to get an idea of the fund's trading strategy. Are the managers employing a buy and hold strategy? Or, is the management team aggressively trading within the mutual fund?

If you are near retirement or already in retirement and currently own mutual funds, please feel free to contact us to discuss how your funds rate with Morningstar.

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