What Do Mutual Fund Ratings Involve?

Investors who want to restrict or reduce their risk often pick mutual funds. Mutual funds are a diversified group of bonds, money market securities or stocks that generate returns from more than one source. However, thanks to their diversification, the risk involved is reduced or limited. Mutual fund ratings are used to assist smart investors derive which funds are best for them, based on the extent of risk that is involved. Different companies determine the fund rating based on their own criteria.

Morningstar
Morningstar has been rating funds since 1985. They allocate 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.
This company has been analyzing funds and helping investors select the best mutual funds for them since 1971. Lipper ranks funds based on performance risk, but is based on poor or risky performance meaning that the higher the risk, the higher the rating. The lower the risk, the less chance the investor has of losing money. Lipper has a five point rating system that includes five different criteria (total return, consistent return, preservation, tax efficiency and expense) to help determine the actual risk of a fund.

Business Week
Subscribers of the Business Week magazine are treated annually to the Mutual Fund Scoreboard, which rates funds on several criteria. Looking for something more current? Check out their website where you can find the results updated monthly. The funds earn their rating by their scoring in different areas, but get their overall rating by how well they have performed over a 5 year period, based on a risk adjusted return. Each fund is then assigned a grade score from A to F. Its the A rated funds that you should consider for your portfolio.

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.

The wise investor will not rely on only one rating system, but, in fact, several in order to obtain a clear picture of a mutual fund's risk factor. While past performance of a fund may shed a little light on the fund's risk factor and viability, future performance can not be predicted based solely on this criteria. A complete picture of the company and the fund must be obtained in order to fully assess the potential risks and strength of the fund. Even then it is not an exact science and there are no guarantees.