Using mutual fund ratings is a very common way for investors to decide which mutual funds to invest in. Mutual fund ratings can be a valuable tool to help you distinguish one fund from another. Here are the basics of mutual fund ratings and how you can use them to your advantage as an investor.

How Mutual Fund Ratings Work

Mutual fund ratings are provided by various financial institutions in the market. The most popular mutual fund rating system is provided by MorningStar. Their ratings, utilize a star system to help you determine the quality of a particular fund. The scale goes from one to five stars, with five being the best and one being the worst. Mutual funds strive to achieve the five star rating provided by MorningStar.

MorningStar looks at several different sources of financial information to come up with these ratings. First, they take a look at the past performance of each fund. Then they look at the risk that they use in order to achieve that performance. At that point, all the mutual funds are divided into several different categories. Each category has been ranked from top to bottom. The funds that make the top 10% in each category, receive a five star rating. After that, the next 22.5% of mutual funds in the category receive a four star rating. Using this system, all mutual funds are ranked accordingly to their performance.

Importance of Ratings

As a mutual fund manager, one of your goals is to achieve a four or five star rating. However, as an investor, you should understand that ratings of mutual funds are not everything. Many investors look only at the ratings as a quick way to choose which funds to get involved with. Instead of looking at many different sources of information, they want someone to summarize everything for them in the form of a star rating.

Keep in mind that the star ratings only tell you what they have done the past. There is no way for MorningStar to predict what will happen in the future. Therefore, you should use other methods to help you make your decision for which mutual funds to choose. Use the ratings systems as a confirmation of your own research.

When you consider how they come up with the ratings, nearly a third of all mutual funds that are available would be considered four and five star funds. This does not narrow the field down as much as you would like. Therefore, you will need to do your own research to make sure the make the best decisions.

One problem with the MorningStar rating system is that it groups every fund into some sort of category. However, due to the unique trading styles of some funds, they do not fit nicely into a particular category. Therefore, they may be competing against funds that are completely different. Keep this in mind when you are making your investment decisions.

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