There are about 10,000 mutual funds in the U.S.. As an investor, how do you know which one is the best for you? Morningstar rolled out its star rating system to help investors separate the good mutual funds from the bad ones. Based on each mutual fund's past performance, adjusting risk and rewards, Morningstar ranks mutual funds within the same category on a scale from one to five stars, with five stars being the best. Barron reported that about 10% of mutual funds in any fund category get five stars.
Investment data shows that investors have consistently and increasing invested in four- and five-star mutual funds. It's important to keep in mind while the star rating is helpful, it can't tell the whole story of any mutual fund. First of all, rating is based on past performance so it's backward looking and is not necessarily a good prediction for future performance. Out of the 827 mutual funds that had five-star ratings 10 years ago, only 45% still have a five or four-star ratings today. Secondly, the rating doesn't take into consideration of some other important factors that can impact fund's performance, such as manager tenure and certain fees the fund charges.
Morningstar recognized the limitation of the star-rating system. About five years ago, it rolled out an analyst rating system to go hand-in-hand with the star rating system. The analyst rating ranks funds with three positive ratings of Gold, Silver, and Bronze, a Neutral rating, and a Negative rating. According to Morningstar's website, the medal rating " is based on the analyst's conviction in the fund's ability to outperform its peer group and/or relevant benchmark on a risk-adjusted basis over the long term. If a fund receives a positive rating of Gold, Silver, or Bronze, it means Morningstar analysts think highly of the fund and expect it to outperform over a full market cycle of at least five years."
Both Morningstar star-rating and analyst rating systems are very helpful tools. But investors should still do their own due-diligence when selecting which funds to invest and shouldn't overly rely on these tools.