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New Morningstars Are Born

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By Robert Brokamp (TMF Bro)
July 3, 2002

When it comes to choosing mutual funds, many investors get stars in their eyes -- Morningstar's stars, that is. The Chicago-based research firm has been the premier source of mutual fund analysis, providing statistics, commentary, and, since 1985, its famous five-star rating system. However, starting this month, Morningstar will change the way it allocates its astral awards.

Here are the two biggest changes:

• Previously, funds were grouped according to four very broad asset classes: domestic-stock funds, foreign-stock funds, taxable-bond funds, and municipal-bond funds. Now, funds will be grouped according to 48 categories. Thus, a fund's performance will be measured against the performance of other funds in the same category. According to Morningstar's Russel Kinnel, "A large-growth manager has to produce greater returns or take on less risk in comparison with other large-growth managers in order to get five stars."
• A new risk-adjusted return measure will more accurately express a fund's volatility, with a greater emphasis on quick drops in value. (The old measurement of risk just indicated whether a fund underperformed the 90-day Treasury bill.) This should reveal whether a fund has had consistent returns, or if its performance was due to short-term swings. It also assumes that, in Morningstar's words, "investors are more concerned about a possible poor outcome than an unexpectedly good outcome."

Under the previous system, your small-cap value fund, for example, could beat 80% of the small-cap value funds in the world but still just get just two or three stars. How? Because small-cap value stocks were out of favor and didn't perform well compared to the rest of the domestic-stock universe. This happened during the late '90s, when large-cap growth stocks ruled. Under the new system, you'll be able to more easily zero in on the best-performing funds in the category you're looking for.

That is, if you're into that sort of thing. While we think it makes sense to compare apples to apples, it also doesn't make sense to hold a legion mutual funds. Keep in mind that the average fund holds 80 to 100 stocks. The fund of choice for Fools, a broad-market index fund, holds 500 stocks (if it attempts to match the performance of the Standard and Poor's 500) and maybe thousands of stocks (if its objective is to keep up with the total market). When you own little pieces of that many companies, how much more diversification do you need?

For many people, it's certainly reasonable to own investments other than an index fund. If you're one of those people, and you're interested in mutual funds, consulting Morningstar is an excellent start.

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