Morningstar’s Risk-Adjusted Ratings

The characteristics of the “risk-adjusted rating” (RAR) on which Morningstar bases its “star ratings” and “category ratings” are analyzed, and the RAR is compared with more traditional mean–variance measures. The RAR measure has characteristics similar to those of an expected utility function based on an underlying bilinear utility function. These characteristics are of some concern because strict adherence to maximizing expected utility with such a function could lead to extreme investment strategies. This study finds that Morningstar varies one of the parameters of this function in a manner that frequently produces results similar to the results of using the excess-return Sharpe ratio. Finally, the argument is presented that neither Morningstar’s measure nor the excess-return Sharpe ratio is an efficient tool for choosing mutual funds within peer groups for a multifund portfolio.