Star ratings are a good starting point, but there are other considerations

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Few institutions have much influence in the mutual fund world as the fund-analysis firm Morningstar. Best known for its star-based rating system – in which the best funds receive five-star ratings – Morningstar’s opinion carries heavy weight with those who are analyzing funds for potential investment. But is a five-star rating enough to warrant investment in a fund?

The answer: it depends on your specific situation. Just because a fund is highly rated doesn’t mean that it’s right for you.

What Does a Five-Star Rating Mean?

Morningstar ranks each fund within dozens of different categories (for instance, “High Yield Bond Funds”), giving five stars to the top 10% of funds, four stars to the next 22.5%, three stars to the middle 35%, two to the next 22.5%, and one star to the bottom 10%.

These ratings are based on “risk-adjusted” returns, meaning that the stars reflect not just absolute performance, but also on the risk that the fund is taking to achieve its returns. Funds are grouped according to their investment objectives in order to ensure apples-to-apples comparisons.

In this way, Morningstar provides an easy-to-understand starting point for investors. Rather than having to sort through hundreds of poor performing funds, the star-rating system enabled investors to narrow their focus to those with the best long-term track records. There are two factors to keep in mind, however.

Is the Investment Right for You?

While a five-star rating is a signal of a fund’s past success, it doesn’t provide information on whether the specific investment is appropriate for your situation. For instance, an investor with a low risk tolerance who prefers to keep his or her money safe shouldn’t invest in an emerging market bond fund – even if the fund is ranked five stars.

The wisest course of action is to determine what type of investment is right for you, and – once you have identified specific categories that are appropriate – use the star system as a starting point for further research. A series of articles on how to determine the mix of investments that may be right for your specific situation is available here .

What Does a Fund’s Past Performance Tell us About the Future?

It’s always important to keep in mind that the Morningstar star ratings are based on past performance and are not an indicator of future results. That’s why research into a fund’s objective, holdings, and potential risks – and not just investing on the basis of stars – is essential. Even the best managers have off years, and sustaining outperformance relative to an index or peer group over an extended period has proven to be extremely difficult .

What’s more, managers change over time – meaning that the manager who navigated a fund to a 5-star rating may not be the same manager who’s running the fund now.

It’s also important to keep in mind that focusing on 5-star funds will generally take index funds out of the equation. Index funds, by their very nature, won’t provide consistent, market-beating performance. As a result, an investor who focuses only on five star funds may be limiting their options to funds with above-average expenses (since index funds tend to have lower costs).

The Bottom Line

Morningstar has built an empire on the basis of its in-depth analysis of funds, individual stocks, and the markets, and its rating system can prove very useful for those trying to sort through the thousands of funds that are available. Still, it’s important to keep in mind that the system has its limitations. Be sure to have a full understanding of any investment you may be considering, rather than placing too great of an emphasis on star ratings.