Both the Morningstar and Lipper mutual fund ratings systems employ a peer-based comparative ranking of fund performance over historical periods ranging from 1 year to 10 years. The primary difference lies in the metric(s) used to determine which funds rank highest to lowest in a category (i.e. peer group).

The Morningstar system relies on a single metric: a calculation of risk-adjusted return. The 'risk adjustment' goes beyond something as basic as a Sharpe Ratio (excess return divided by standard deviation of returns) and incorporates a utility function to reflect how investors' trade-off return and risk for factors such as loss aversion. In addition, Morningstar will adjust for taxes in its risk-adjusted return calculation if most investors in that fund qualify for the same tax treatment. The resulting risk-adjusted returns are segmented into five categories (1 to 5 stars) based on a bell-shaped (i.e. normal) distribution.

The Lipper system evaluates fund performance using metrics which, combined together, determine the overall ranking for a fund. These five metrics are (1) Total return (not risk-adjusted); (2) Consistency of Return; (3) Preservation of Capital; (4) Fund Expense; and (5) Tax Efficiency. One advantage of this system is that investors can dig into an overall Lipper ranking to determine which of these five metrics played a key role. On the other hand, the overall ranking is by definition a composite of factors where Morningstar is purely focused on one metric (risk-adjusted return). Funds within the same peer group are ranked into one of five categories numbered 1 to 5 (best to worst) using a flat distribution of 20% each so that an equal number of funds are assigned to each performance category. Lipper also provides an overall fund rating based on total return with capital gains and dividends re-invested.

Further details on each methodology are shown below.

Morningstar Mutual Fund Rating System Methodology

Morningstar Ratings (sometimes referred to as the 'star rating system') has the following characteristics:

  • Mutual funds are evaluated against a peer group
  • Ratings are based on the funds' risk-adjusted returns

Morningstar rates mutual funds from 1 to 5 stars based on how well they've performed (after adjusting for risk and accounting for sales charges) in comparison to similar funds. The risk adjusted return is more than a simple Sharpe Ratio calculation (excess return divided by the standard deviation of returns) and incorporates a utility function to reflect how investors' trade-off return and risk for factors such as loss aversion.

Within each Morningstar Category, the top 10% of funds receive 5 stars and the bottom 10% receives 1 star. The 4 star category (immediately below 5 stars) encompasses 22.5% of the peer group as does the 2 star category (immediately above the 1 star category). The middle category (3 stars) encompasses the remaining 35% of funds. In this respect, the 1 to 5 star rating system distributes all funds in a peer group roughly according to a normal distribution.

Funds are rated for up to three time periods-three-, five-, and 10-years and these ratings are combined to produce an overall rating. Funds with less than three years of history are not rated.

Fund categories are defined based on the following considerations:

  • Funds are grouped into peer groups according to the types of investments in their portfolios
  • In general, a single return benchmark should be a valid basis for evaluating returns of all funds in a category
  • In general, funds in each category can be considered reasonable substitutes for the purposes of portfolio construction
  • Membership of a fund in a particular category is based on the fund's long-term or 'normal' style profile, based on three years of portfolio statistics

Ratings are objective, based entirely on a mathematical evaluation of risk-adjusted past performance. They're a useful tool for identifying funds worthy of further research, but shouldn't be considered buy or sell signals.

Lipper Mutual Fund Rating System Methodology

Lipper ranks mutual funds according to a peer-based performance system which measures returns according to specific time frames and fund classifications (small, mid, multi and large-cap). Mutual fund returns are assigned a rank that places each fund within a group - the lower the number rank, the better the fund performed compared to other funds in the classification group. For example, a rank of 24 indicates that the fund has the 24th best rate of return in its category. In effect, Lipper ranking reflects how well the fund performed compared to its peers for a given time period. Because the number of mutual funds in a classification group can vary widely, Lipper also calculates a percentile measure for each fund.

Lipper ratings are derived from formulas that analyze funds against clearly defined criteria. Funds are ranked against their peers on each of five measures:

  1. Total Return
  2. Consistent Return
  3. Preservation
  4. Expense
  5. Tax Efficiency

Each of these criteria is defined below:

Scores are subject to change every month and are calculated for the following periods: 3-year, 5-year, 10-year, and overall. The overall calculation is based on an equal-weighted average of percentile ranks for each measure over 3-year, 5-year, and 10-year periods (if applicable). For each measure, the highest 20% of funds in each peer group are named Lipper Leaders. The next 20% receive a rating of 2; the middle 20% are rated 3; the next 20% are rated 4, and the lowest 20% are rated 5.

1. Total Return Criterion

Lipper ratings for Total Return reflect funds' historical total return performance relative to peers. A Lipper Leader for Total Return is a fund that has provided superior total returns when compared to a group of similar funds.

2. Consistent Return Criterion

Lipper ratings for Consistent Return reflect funds' historic returns, adjusted for volatility, relative to peers. A Lipper Leader for Consistent Return is a fund that has provided superior consistency and risk-adjusted returns when compared to a group of similar funds.

3. Preservation Criterion

Lipper ratings for Preservation reflect funds' historical loss avoidance relative to other funds within the same asset class. A Lipper Leader for Preservation is a fund that has demonstrated a superior ability to preserve capital in a variety of markets when compared with its peers.

4. Expense

Lipper ratings for Expense reflect funds' expense minimization relative to peers with similar load structures. Lipper Leaders for Expense are funds that have successfully managed to keep its expenses low relative to its peers and within its load structure.

5. Tax Efficiency

Lipper ratings for Tax Efficiency reflect funds' historical success in postponing taxable distributions relative to peers. A Lipper Leader for Tax Efficiency is a fund that has been successful at postponing taxes over the measurement period relative to similar funds.