What Do Mutual Fund Ratings Involve?

What Do Mutual Fund Ratings Involve?
By: Christopher Smith

If you want to lower your risk, diversification is the key. This is why many active investors pick mutual funds. As a diverse group of stocks, bonds or money market securities, many mutual funds hold potentially hundreds and often thousands of individual stocks. The risk is limited since not all stocks move in the same direction at the same time. Thus, if individual stock moves lower, its possible that others will be higher. The challenge with mutual funds is in attempting to pick the right one for you. There are tens of thousands of funds to choose from, depending on your view of the future of the markets. There are several companies that offer their own mutual fund ratings based on their own criteria, to help investors find the right fund for them.

Morningstar
Morningstar has been rating funds since 1985. They accord 1 to 5 stars to various funds and use it as a guidance method for their investors who are looking to enhance their portfolio. The rating system is based on the company's initial risk score of the fund. They then subtract that score from the five year return of the fund and arrive at a rating that is risk adjusted. The problem here is that the rating system is based on past performance and has little value in determining the actual risk factor of the fund. This is probably not the most reliable source of determining future risk of your funds.

Lipper, Inc.
Older than Morningstar by almost 15 years, Lipper has been providing analysis for investors since 1971. Based on performance risk, each fund is assigned a rating based on the chances of an investor losing their money. The higher the rating, the better the odds of losing money. This 5 star rating system also factors in five different criteria (preservation, tax efficiency, expense, and total return, and consistent return) which helps to determine the real risk of the fund.

Business Week
Their Mutual Fund Scoreboard is carried annually in their magazine, but savvy investors can access that scoreboard at any time by going to Business Week's website and accessing the Mutual Fund Scoreboard, which is updated monthly. They rate funds on quite a few different criteria, but they obtain the overall rating by assessing the performance over a five year period, based on risk adjusted returns. They deliver the ratings in a letter grade with A being superior and F being very poor.

Schwab Mutual Fund OneSource Select List
Schwab's experts have created a list of pre-screened, no load, no transaction fee funds. This list is updated quarterly and utilizes a list of strict criteria to arrive at the ratings. These criteria include a minimum three year performance track record and have a minimum of $40 million in assets (in most cases). The funds that make the list are rated on risk, performance, diversification and other factors.

As a smart investor, you shouldnt rely on just one fund rating system. Instead, consider using several different systems to determine the best one for you. Past performance is helpful in establishing how well the fund has performed compared to the major indexes, but is useless unless used in conjunction with other variables. Assess the risks, get a picture of the strength of the fund, specifically the mutual fund manager. While a high mutual fund rating may guide you in the right direction, its by no means a sure bet. Do your due diligence.