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to come up with a general rating for all mutual funds. But two companies have become well-known by doing just that.

Morningstar is the most recognized name in the mutual fund rating business. Morningstar’s rating system is a simple star rating. Funds are given between one to five stars. Those with five stars are considered first rate and those with one star are basically last in the ranking order. The others fall in the middle in the order of increasing investment quality. The stars are assigned to a fund not based on a firm criteria, but mostly based on how well it has performed compared to other funds. Based on the fund’s continuous performance, it is assigned a risk score and a return score. The risk score is then subtracted from the return score and the resulting number is tabulated with those of all other funds. Then the top 10% ranking funds are assigned five stars, followed by the next 22.5% which receive four stars, and so on all the way down to the bottom 10% which receive one star. The star rankings cover 3, 5, and 10-year periods. Lastly, the individual star rankings from the various year-long periods are averaged (with the most recent years receiving higher weights) and a final star rating for the fund is produced.

So what exactly does it mean when a fund receives five stars? Well, it could mean that the fund has delivered excellent returns in the past or perhaps it has had a great track record on risk avoidance. One cannot simply rely on the star system to evaluate a fund. There are plenty of critics out there blasting the Morningstar’s star rating for the same reason. In my opinion, the star rating can be a useful tool when you want to quickly scan a number of funds in terms of their quality. You can consult the Morningstar’s Web site to get the latest star rating on a fund, as long as you recognize that the star rating is no substitute for good research. …