Smart Investor

Decoding Morningstar’s Mutual Fund Analysis

If you have spent any time at all analyzing mutual funds, you have probably run across ratings and analysis from the investment research firm Morningstar. While Morningstar provides research on stocks and market data on a large variety of financial products, the firm is perhaps most widely known for its research and ratings of mutual funds, especially the ubiquitous Morningstar Style Box and Star ratings.

The Morningstar Style Box is the 3×3 matrix you see which visually represents the style of the fund in question. Because of the inherent differences between equities and bonds, Morningstar created two different boxes—one for each type of security.

The Equity Style Box plots stock mutual funds based on two characteristics: market cap (on the vertical axis) and value vs. growth (on the horizontal axis). Below, you will see the Morningstar Style Box for American Funds’ Growth Fund of American (AGTHX) as it appears on Yahoo! Finance. According to the Style Box, this fund is classified as a large-cap growth fund, meaning that the fund invests in large-cap growth stocks. This does not mean that every single stock owned is a large-cap growth stock, but that the average stock, or the “core” portfolio, falls into the large-cap growth strategy.

According to Morningstar, the size variable is relative, which allows for flexibility during market movements. Instead of defining “large-cap” as stocks with a market cap larger than, say $10 billion, Morningstar uses the “large-cap” term to refer to stocks in the top 70% of market cap, while “mid-cap” is used for the next 20% of stocks, and small-cap is the smallest 10%.

The growth and value characteristics are calculated by a proprietary Morningstar formula that takes into account both historical and forward-looking P/E ratios, dividend yields, and other financial metrics. Each fund receives a score based on this criteria, and the score dictates the fund classification as either growth, value or a blend. The size variable and the growth vs. value variable are then combined to determine where the fund should fall on the Style Box.

The Bond Style box plots bond mutual funds based on the average credit quality of the underlying bonds and the effective duration (or interest rate sensitivity) of the bond portfolio. For example, if a bond fund is not highly affected by interest-rate changes and also has high credit quality, it will be plotted in the upper-left of the box. The more sensitive the portfolio is to interest rate changes, the further the fund shifts to the right; the lower the credit quality, the further the fund shifts to the bottom.

The Star Rating

Morningstar also provides historical performance ratings for mutual funds based on the classic 5-star scale, where being awarded 5 stars is the best rating. In order to arrive at the ratings, Morningstar first calculates risk-adjusted returns for each fund and then ranks the returns of each fund relative to the other funds in the same category. The funds that rank in the top 10% of historical risk-adjusted returns earn 5 stars, followed the by next 22.5% that earn 4 stars, the middle 35% earn 3 stars, with the lowest performers earning 2 or 1 star(s).

While the Style Boxes don’t provide in-depth analysis into a mutual fund, they can be very helpful when trying to quickly evaluate whether or not a fund will suite your tastes. While it may be hard to tell the style of the John Hancock Global Opportunities Fund (JGPAX) just from its name, the style box will quickly reveal its mid-cap growth bent. Similarly, the Star ratings can’t tell you how the fund will perform in the future, but can give you a brief overview of how the fund has performed relative to its peers in the past. By combining these two metrics, you can quickly see if the fund you are researching is worth further analysis.

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