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Mutual fund ratings were developed as a means to help investors evaluate and choose a mutual fund. However, ratings alone should not be used when choosing a fund that's right for you.

In this podcast, Chris Philips, a senior analyst in Vanguard's Investment Strategy Group, takes a closer look at the Morningstar ratings system, the most widely used ratings system in the industry. He highlights some of the benefits of star ratings and explains why other factors should be considered when choosing funds to help you achieve your financial goals.

He begins by explaining how Morningstar determines its fund ratings.

Chris Philips: Morningstar, they do have a fairly substantial methodology; however, it boils down to primarily performance ranking on a risk-adjusted basis. They'll look at not only returns, but also how risky did the fund get to achieve those returns. They look primarily at 3-year returns and then supplement that with 5- and 10-year returns, but the focus is primarily on the shorter-term performance metrics.

Narrator: Ratings can be very informative, but they shouldn't be the only tool in an investor's tool box.

Chris Philips: We would encourage investors to evaluate the star rating or past performance as one additional metric in addition to costs, in addition to the concentrated nature of the portfolio; how many names or stocks or bonds does a mutual fund have; where does it fit in their portfolio in terms of style and size, to a large-cap growth vs. small-cap value, for example. Again, it's one tool. Do we think it's the most important tool, we do not; but it is an additional tool that investors can use to try and winnow down the thousands of funds that are out there to choose from.

Narrator: It's also important to remember that ratings cannot indicate how a fund will perform in the future. A 5-star rating does not ensure higher returns and a 1-star rating does not equal lower returns.

Chris Philips: Some of the research that we looked at, we actually found that there's really no forecasting ability of this star ranking system or other ranking systems out there. That it really does fall into that disclaimer that past performance is no guarantee of future performance.

I think that the cyclicality that is inherent to the markets—whether you look at the bond market, whether you look at the stock market—there's always going to be a leader, there's always going to be a follower in terms of sectors within the market.

But the cyclicality and the rotation from one style to another style in terms of outperformance tend to be quite random.

Narrator: Investing in only highly rated funds (or avoiding poorly rated funds) may seem like a good investment strategy, but it may lead to higher costs and lower returns. Chris explains.

Chris Philips: There's tremendous volatility in performance itself, but that performance volatility lends itself to ranking volatility.

But most investors will look at rankings or look at trailing performance and they'll say, that fund has done very well. I want some of that fund in my portfolio. I'm going to build a portfolio of 5-star, 4-star funds, and I'm going to generate success over time.

Well, that ends up being what we would call a bottom-up approach there, picking funds before they're thinking about their long-term investment strategy. What that ultimately leads to is more volatility in a portfolio, much more concentrated portfolios, portfolios that may actually be misaligned with the long-term objectives of the investor.

Narrator: Before you start considering individual investments or their ratings, you should first determine your asset allocation—the percentage of your portfolio that's invested in stocks, bonds, and cash. An asset allocation in line with your goals, time horizon, and risk tolerance makes picking individual investments easier.

Chris Philips: Whether it is saving for college, whether it's spending in retirement, whether it's saving for retirement, whatever it may be. If you focus primarily on your objectives and what levels of risk that you're willing to take in order to achieve those objectives—whether it's short-term volatility, whether you're investing internationally, whether it's currency risk—whatever those risks may be, once you evaluate the objectives and the risks that you're willing to take, you can then populate your portfolio with funds. We think that's a much better approach to investing over time than simply trying to build a portfolio based on a star ranking or trailing performance.

I think that if investors take anything away from this, it's that the star ranking—whatever ranking methodology they decide to use or build into their portfolio process—they really need to take with a grain of salt. And it could be a good starting point. But they really do still need to dig into the funds, look at the characteristics, evaluate why a fund is returning the levels that it's returning, evaluate the cost, evaluate the manager tenure, various other metrics that are out there. That they can't just take performance at its face value and rely wholeheartedly on one metric vs. another.

Narrator: We hope this Plain Talk on Investing podcast has given you a better understanding of mutual fund ratings and how they can help you determine which investments would be an appropriate option for your portfolio. For more information, visit Vanguard.com.

Thanks for listening.

All investments are subject to risks. Investments in bonds are subject to interest rate, credit, and inflation risk. Diversification does not ensure a profit or protect against a loss in a declining market. Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index. Foreign investing involves additional risks including currency fluctuations and political uncertainty.

There are many mutual fund rating systems, each of which uses quantitative or qualitative metrics, or both, to evaluate funds. The Morningstar system measures how funds have performed against their category peers on a risk-adjusted basis (using a formula that adjusts returns for the specific risks assumed by each fund). Morningstar calculates ratings for 3-, 5-, and 10-year periods, then takes an average of those results to create its overall rating for a fund.

The information presented in this podcast is intended for educational purposes only and does not take into consideration your personal circumstances or other factors that may be important in making investment decisions. It is not a recommendation to buy or sell a particular product and should not be construed as financial advice.

You may access and download this podcast only for your personal and noncommercial use. You may not use it in any other manner, or for any other purpose, without Vanguard's written permission.

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