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Star Power

With thousands of mutual funds available, investors have looked for some help in narrowing down their choices. There are four major mutual fund ranking systems available. The longtime leader in mutual fund information for the average investor has been the star rating system of Morningstar. However, Charles Schwab and Standard and Poors also publish rating systems. Lipper has recently initiated its “Lipper Leader” designation for mutual funds. But the information and rating system provided by Morningstar have become the most popular tools for investors making mutual fund buying and selling decisions. This section discusses Morningstar's star power. Its rating system is based on each mutual fund's historical performance. Indeed, Morningstar considers the rating a measure of achievement, not a predictor of the future. Nevertheless, because of the representativeness bias (see Chapter 2), investors believe that past achievement represents the kind of performance that will occur in the future.

A mutual fund must have been in existence for at least three years for a rating. The fund's returns for the past 36 months are used. Morningstar makes an adjustment to the return for risk and for any loads. This load-adjusted and risk-adjusted return is computed for each fund, and they are ranked and ordered within the four categories (domestic equity, international equity, taxable bond, municipal bond). The funds in the top 10% of their peer group are assigned a rating of five stars. Funds in the next 22.5% receive four stars, the next 35% receive three stars, the following 22.5% receive two stars, and the bottom 10% get one star. This is the Morningstar three-year rating. Morningstar also computes a five-year and 10-year rating using the same procedure with the longer time periods. The Overall rating is a weighted average of these three ratings.


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