Morningstar Shaking Up Rating System

The biggest change is that funds will be ranked and rated within nearly 50 Morningstar Categories, rather than across four broad asset classes, this should help investors to better distinguish between funds that share a similar investment style, the company said. The Morningstar Category Rating will be retired.

The new rating will appear in Morningstar products in the US in July, using performance data for the period ending June 30, 2002. Historical star ratings will not change.

Rank and File

The new star rating system uses the same scale of one to five stars, is load-adjusted, and grades on a bell curve so that similar numbers of portfolios receive one and five stars, the company said.

Morningstar notes that the new system will use an enhanced risk-adjusted return measure based on expected utility theory, which recognizes that investors are:

• more concerned about a possible poor outcome than an unexpectedly good outcome, and
• willing to sacrifice part of their expected return in exchange for greater certainty of return.

Risk Adjusted

The new rating accounts for all variations in a fund’s month-to-month performance, with more emphasis on downward risk. The ratings reward consistent performance, while reducing the possibility of strong short-term performance masking the inherent risk of a fund.

Funds will still be rated for over three, five, and 10 years, however, when a fund changes investment categories, its historical information will be weighted according to the magnitude of the category change, ensuring fair comparisons and minimizing the incentive for fund managers to change their style in an attempt to receive a better rating, the company said.

Share classes are still evaluated separately, but a fund with multiple share classes is counted only once within the rating distribution scale to prevent multi-share class funds from dominating the ratings within smaller categories.