Using Morningstar's New Ratings To Pick Winners

- Alan Lavine and Gail Liberman

Yes. We’ve always said that the mutual fund ratings of Morningstar Inc., Chicago, can help you pick well-managed funds. But please don't bet the ranch on those ratings.

Morningstar recently changed its fund rating system. Funds still are ranked from one star to five stars. Funds rated one star are worst. Those rated five stars are best.

But the most significant change is that funds are ranked and rated within nearly 50 narrow Morningstar categories rather than across four broad asset classes. Rankings formerly had been limited to these categories: U.S. stock, international stock, taxable bond, and municipal bond. Example of one of the new categories: All funds that own undervalued small company stocks.

The new star system also looks more at the downside of a fund's performance than the previous system. It uses an enhanced risk-adjusted return measure and accounts for all variations in a fund's month-to-month performance.

"Our goal is to provide tools that help investors make better decisions," says Don Phillips, Morningstar managing director. "Too often, investors pick good funds but use them poorly. They buy after a hot streak and sell when things go bad. In effect, they are buying high and selling low.

"By better preventing the ratings from being inappropriately tilted toward some categories and away from others, we hope the new Morningstar rating will help investors to focus on good planning, diversification, and fund selection."

Be advised. The ratings are based on a combination of long-term and short-term past performance. Past performance is no indication of future results. All the star system shows is whether the fund has been on the right track.

If we were putting together a series of mutual funds for myself, we would build it around an S&P 500 index fund. Then I would look at actively managed stock funds with good long-term track records.

We would use the star ratings only as a rough guide. It is important to consider some of these other factors before buying a fund:

• Make sure the fund fits with your investment comfort level. If you're short cash, you don't want to invest in a risky stock mutual fund.
• Evaluate the fund's stock holdings. Make certain it invests in good quality companies.
• Look at its past performance year by year compared with similar funds.
• Compare fund expenses.
• Check how long the fund manager has been at the helm.

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Alan Lavine and Gail Liberman are husband and wife columnist and authors of The Complete Idiot's Guide To Making Money With Mutual Funds, (Alpha Books).