The Morningstar risk rating, commonly known as the Morningstar rating, is a crucial tool for investors navigating the vast universe of publicly traded mutual funds and exchange-traded funds (ETFs). Created by Morningstar, an esteemed investment research firm, this rating system is designed to provide a comparative assessment of funds based on their relative risk levels.
What Is the Morningstar Risk Rating?
The Morningstar rating operates on a scale from 1 to 5 stars, signifying the relative risk and performance of a fund.
- 1 Star: Represents the poorest performers in terms of risk-adjusted returns.
- 5 Stars: Denotes the best performers, showcasing exceptional risk-adjusted performance.
The ratings focus primarily on the volatility of a fund's monthly returns, with a particular emphasis on downside risk. By comparing how much a fund's returns fluctuate relative to similar funds, Morningstar provides investors with insights into which funds may be appropriate for their risk tolerance levels.
Key Takeaways
- The Morningstar rating is integral in helping investors identify appropriate funds based on risk.
- The system segments the top 10% of funds as "high risk," while the lowest measured 10% are rated as "low risk."
- Morningstar employs historical performance over a range of three, five, and ten-year periods to inform these ratings.
- The ratings serve merely as a starting point for more in-depth evaluation and are not definitive buy or sell signals.
How Does the Morningstar Risk Rating Work?
Morningstar categorizes funds to analyze their performance and risk levels effectively. Here’s a breakdown of how funds are rated within categories:
- 10% of the category's funds are classified as "low risk."
- 22.5% are "below average," indicating slightly higher associated risk levels.
- 35% fall into the "average" category for risk.
- Another 22.5% of funds are considered "above average."
- The top 10% of funds receive a "high risk" label.
Subsequently, for funds with less than three years of performance history, Morningstar does not assign ratings. For those with a longer track record, the firm averages the risk measures across varying timeframes to create a comprehensive rating.
Additional Insights
- Morningstar also provides category and peer-group ratings, allowing investors to make more compared decisions. For instance, as recorded at the end of 2018, municipal bond funds received a 3.9-star rating while domestic stock funds earned a 3.4-star rating.
The Limitations of Morningstar Risk Ratings
Despite the acclaim the Morningstar risk rating receives, it has received criticism from various financial analysts. Concerns primarily stem from the method's comparative nature, where funds are analyzed against each other but not against broader market conditions. This method can misrepresent a fund’s overall viability if market dynamics are not taken into account.
For example, during bull markets, conservative funds often yield better results. Conversely, in bear markets, riskier assets may outperform relatively stable funds. This phenomenon leads some investors to prefer ratings and analyses that consider overall market conditions, such as those produced by financial publications like Forbes and U.S. News & World Report.
Example of Morningstar Risk Ratings
An illustrative example of how Morningstar assigns risk ratings is the iShares Nasdaq Biotechnology ETF (IBB). This fund holds an "above-average" risk rating of three stars from Morningstar, based on performance over three, five, and ten years. Over the past decade, the ETF has achieved an impressive annualized total return of 15.38%, surpassing the benchmark S&P 500 index’s 11.59%.
Other Risk Rating Providers
Morningstar is not the sole rating provider; other prominent entities include Thomson Reuters Lipper, Zacks Investment Research, Standard & Poor's, and TheStreet. Many leading business and finance publications integrate Morningstar’s ratings or similar analyses when providing investment advice.
Conclusion
The Morningstar risk rating is a significant metric for investors seeking to understand the risk-adjusted performance of mutual funds and ETFs. While it serves as a beneficial starting point for fund evaluation, investors should remain cognizant of its limitations and consider incorporating additional analyses and insights into their investment decision-making process. By understanding both the benefits and drawbacks of the Morningstar risk rating, investors can make more informed choices, aligning their portfolios with their personal investment goals and risk tolerance.