Help for the Starstruck

Morningstar is overhauling how it awards star ratings to mutual funds. What does it mean for investors?

Professional investors generally don't pay much attention to the star system for rating mutual funds, but clients of advisors and the media find focus a lot of attention on the stars. Funds that earn four- or five-star ratings from Morningstar Inc. routinely tout this fact in ads, and the vast majority of investment dollars historically flowed to those funds. Four- and five-star funds got $119 billion in new assets in 2001; all other funds, taken together, had net redemptions of $79 billion, according to Financial Research Corp. in Boston.

Now, however, Morningstar is overhauling its method of choosing top funds, and the reason for the change underscores the importance of one of the most basic investment principles: diversification. Under the current system, Morningstar ranks mutual funds according to risk-adjusted performance during periods of three, five, and 10 years, awarding five stars to the top 10% for each time period and four stars to the next 22.5%. That won't change this summer, when the company revamps its approach. What will change are the groups that Morningstar divides the fund world into when conferring its coveted stars.

Currently, Morningstar uses just four very broad asset classes: domestic stock, international stock, taxable bond, and municipal bond. That means that the performance of every U.S. equity fund is compared with that of every other U.S. equity fund, regardless of investment style or the kinds of stocks a fund holds. Starting in July, Morningstar will narrow those classifications considerably. It will assign stars to mutual funds in 48 categories-such as small-cap growth, large-cap value, technology, European equity, and long-term bond.

The problem with Morningstar's old rating system is that it gives an unfair advantage to some pretty lackluster mutual funds. Consider what happened in 1999, at the height of the technology stock boom. The funds buying Internet, computer, or networking companies were racking up eye-popping gains. In its ranking of domestic stock funds, any tech fund that had been around for at least three years was almost guaranteed to earn four or five stars from Morningstar. Meanwhile, most funds that invested in large, undervalued companies ranked near the bottom of the domestic equity rankings, often getting just one or two stars. But did that mean that the worst tech fund was a better investment than the best large-cap value fund? Not at all.

That's where diversification comes in. A chief failing of the old Morningstar system was that the funds it encouraged investors to buy tended to be similar to each other- whatever was popular at the moment. But as everyone now understands, what goes up will come down, and the more prudent way to create a portfolio is to spread bets across several fund types, choosing the best fund you can find to represent each asset class of a diversified portfolio. The new Morningstar system is a step toward helping starstruck investors in a more responsible fashion, but selecting great funds is still more than a numbers game.