Morningstar of Chicago announced last week that its system for rating mutual funds, commonly known as the "star rating," will be altered this summer to include a broader number of categories, which the company hopes will render it more relevant to the way investors use mutual funds.

The company's system, introduced in 1985, gives funds a rating of between one and five stars. Many investors use the system, sometimes to the dismay of financial planners, as a key way to choose funds. And fund companies often boast of the ratings in their advertising.

Morningstar plans to now use a total of 50 categories in its rating system. Before, funds were compared across four broad asset classes - U.S. stock, international stock, taxable bond and municipal bond. The categories now include broad monikers such as "large value" and "large blend" as well as more-specific categories such as "specialty technology" and "diversified world."

Morningstar spokeswoman Martha Conlon-Moss said those headings had previously been used to create a category rating for funds, which the firm had been using since 1996 as a precursor to the new ratings system. However, that rating system will now be cast aside because the new formula renders it obsolete, she said.

The changes will go into effect in July using performance data for the period ending June 30.

More Appropriate

Ric Edelman, a financial planner based in Fairfax, Va., suggested that Morningstar change the way it rates funds in a chapter in his book, Discover the Wealth Within You, published this month by HarperCollins of New York. Edelman applauded the company's move, saying that the previous system of using only four headings resulted in funds being inappropriately lumped in the same categories.

"It was ridiculous," he said. "You had convertible bond funds in the same category as balanced funds. The four categories were so generic, you had funds being compared to other funds that had nothing to do with each other."

Although there will naturally be fewer funds in each category because the array has expanded from four to 50, the change will not result in more five-star funds, Morningstar said.

The reason is that the firm uses a bell curve that allows only 10% of the funds in any category to receive a five-star rating. "It's always the same percentage of all funds that get five stars," wrote Morningstar researcher Michele Gambera in an e-mail. "The difference is that the five-star will belong to more categories, thus encouraging investors to build more diversified [or safer] portfolios."

Reaching Finite Goals

Morningstar Managing Director Don Phillips said the firm updated its formula because more investors were using funds to achieve a finite goal in their overall investment plans.

"When we first introduced the Morningstar rating, most investors owned one or two funds," Phillips said. "Today, investors are searching for multiple funds that play specialized roles in an overall portfolio. As such, a rating based on categories rather than broad asset classes is a more logical starting point for identifying funds that have potential merit."

Still, Edelman said consumers often rely too steadfastly on the system and they need to know more about how it works. He cited Gambera's point that 10% of the funds in a category end up with five-star ratings, which means that investors are simply choosing a fund that has performed well in the past.

In addition, he said Morningstar updates its ratings monthly, which means that if a consumer buys a five-star-rated fund one month, that vehicle won't necessarily hold onto the rating throughout the year.

So, when clients ask Edelman for a five-star fund, he asks them, "Do you want a five-star fund for May or for June?"

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