Every investor – whether a beginner or experienced – faces the same question: which ETF to choose? To make selection easier, atlasETF has introduced rankings and, in addition, the world’s most popular five-star rating system from Morningstar, visible with most ETFs.
Thanks to the star-based ratings, you can distinguish within seconds which funds have historically combined high returns with moderate risk, and which have performed less well. This article, in simple language, explains how the Morningstar stars work, how their values are determined, and how to use them wisely.
What is the Morningstar Rating and Why Was It Created?
The Morningstar star rating system was created in 1985 in response to the difficulties investors had in comparing funds. Its creator was Joe Mansueto, the founder of Morningstar. The system is designed to:
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Quickly select the best funds in a given category
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Compare risk-adjusted performance – but only with funds of similar strategies
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Ensure objectivity by basing results on mathematical formulas, not opinions
Previously, investors mainly focused on short-term returns, ignoring both costs and risk. Morningstar updates its rankings regularly (once a month) to remain a practical tool for both novice and professional investors.
Now, in a few seconds, an investor can check how many stars (1–5) an ETF fund has.
Morningstar applies the same rating methodology to all ETFs, whether they are from the US, Canada, or Europe. However, ETFs are categorized and rated within their local Morningstar categories, which can lead to different ratings for similar funds. Therefore, it makes no sense to compare, for example, US ETFs with those from Europe, even if they replicate a similar index.
A category is a group to which ETFs with similar strategies and investment characteristics are assigned. This way, performance and risk are compared only among funds investing in the same way, in similar markets or similar assets. Examples of categories are “US large-cap equities,” “euro government bonds,” or “global large-cap blended equities.” Ratings are always assigned against ETFs from the same category to ensure a fair and reliable comparison. Thanks to Morningstar categories, it’s easier to find a fund that matches your expectations and to objectively assess its quality against the competition.
How is the Star Rating Created?
Step 1. Collecting data
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3-, 5-, and 10-year ETF returns
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all costs borne by the investor
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Morningstar category assignment
Step 2. Calculating MRAR – risk-adjusted return
Morningstar’s methodology dislikes sudden drawdowns, so it has developed the Morningstar Risk-Adjusted Return (MRAR) metric. The MRAR metric lowers a fund’s “score” when its monthly results are volatile, especially downward.
MRAR answers the question: “What guaranteed, risk-free annual rate of return would I need to receive, to feel as satisfied as I actually am with the variable, historical performance of this fund?”
Step 3. Comparison within category
The MRAR value of each ETF is compared with other funds in the same category (e.g. US large-cap equities).
Step 4. Assigning stars
The distribution of ratings is fixed:
★ ★ ★ ★ ★ – 10% of the best funds
★ ★ ★ ★ – next 22.5%
★ ★ ★ – the middle 35%
★ ★ – next 22.5%
★ – the weakest 10%
Step 5. Overall rating (“overall”)
AtlasETF presents the overall rating, which is a weighted average of ratings from the 3-, 5-, and 10-year periods.
This layout ensures that the most recent 3 years always influence the rating—even for “ten-year-olds.” ETFs younger than 3 years (36 months) do not receive Morningstar star ratings.
Some ETFs will never get a rating, even after 3 years:
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Leveraged and inverse ETFs
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Some commodity funds (e.g. gold)
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Exchange-Traded Notes (ETNs)
MRAR Explained in Plain Language
MRAR (Morningstar Risk-Adjusted Return) is a way of measuring the so-called “certainty equivalent” – that is, the steady, guaranteed return that would give you the same satisfaction as participating in a risky investment with uncertain outcomes.
For most people, the certainty equivalent is lower than the average outcome of the risky investment – because we value peace of mind more than unpredictability. That’s how our psychology works: we value stability and the absence of unexpected losses higher than the “chance of the occasional high return,” especially if there’s a risk of losing a lot along the way.
Imagine two piggy banks for a whole year:
- Piggy Bank A (steady): Each day you put in exactly $2. No surprises, no stress. At the end of the year, you have $730.
- Piggy Bank B (unpredictable): Sometimes you put in $10 (great!), sometimes you have to take out $8 (ouch!). At the end of the year, you may still have about $730, but you had nerves and uncertainty along the way.
MRAR says: “How much certain money per day would you prefer to get instead of this nervous game with Piggy Bank B?”
If you say “1.80 zł per day for sure is enough for me,” that means MRAR for this fund is about 1.80 zł per day – a bit less than the unpredictable piggy bank, because you value peace of mind more than excitement
MRAR shows how much you would have to earn “for sure” not to want to take the risk – even if you could potentially earn a bit more in the risky investment, but at the cost of stress and uncertainty.
Why Does This Make Sense in Practice?
- People don’t like financial surprises
- Research shows the average person prefers to have a little less, but for sure, than to risk more with the possibility of loss.
- Losses “hurt” more than gains bring joy
- If you lose 100 zł, you feel worse than you feel good when earning 100 zł. That’s normal.
- MRAR is a “translator” between risk and peace of mind
- It tells you: “This risky fund is worth as much as a calm fund earning X% per year”.
MRAR – A Practical Example
Fund ABC:
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Earned an average of 8% yearly over 5 years
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But had large fluctuations: once +15%, once -5%, once +12%, etc.
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MRAR = 6%
What does it mean? The average investor would prefer a guaranteed 6% per year than to risk it with this fund, which delivers 8% on average, but with lots of ups and downs.
The closer MRAR is to the fund’s actual return, the “calmer” the fund. The greater the difference, the more stress and volatility.
Examples:
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Fund earned 10%, MRAR = 9.5% → very stable
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Fund earned 10%, MRAR = 6% → very volatile, stressful for investors
MRAR is the “guaranteed amount” you’d rather get annually than struggle with a fund that’s unpredictable, even if potentially more profitable.
That’s it! You don’t need to understand the complicated math (if you don’t want to)—just remember: the higher the MRAR relative to return, the calmer and less stressful the fund was for the investor. Or even easier: just check the number of stars for an ETF on our portal.
The MRAR mechanism is based on expected utility theory with a risk aversion parameter gamma = 2. This theory assumes that investors prefer stable returns over volatile ones, even if average returns are the same.
The parameter gamma = 2 stands for moderate risk aversion typical of the average retail investor. This does not mean that losses “hurt twice as much”—it is a parameter of the utility function that measures the curvature of risk preferences, not the asymmetry between gains and losses.
That’s why MRAR “rewards” stable, predictable gains and “punishes” high volatility and frequent declines more than it rewards occasional spectacular results.
Practical Interpretation of Star Ratings
Sample table interpreting Morningstar stars (examples are for illustration only):
| Sample ETF | Stars | What does it mean in practice? |
|---|---|---|
| Stable | ★★★★★ | Leader – worth further analysis (top 10% of category) |
| Solid | ★★★★ | Solid choice (good risk-return compromise) |
| Average | ★★★ | Average for its category (neither leader nor laggard) |
| Volatile | ★★ | Below average performance |
| Risky | ★ | Caution: high stress or poor results |
Remember: compare stars only within the same category. Five stars in bonds does not mean that the fund is “better” than four stars in stocks—they are two different worlds.
How Often Do Stars Change?
Morningstar recalculates ratings each month after closing the data for that month. Thanks to this, you always have an up-to-date picture and the stars reflect the current state of the funds.
MRAR for the Curious (you don’t need to read this if you don’t like mathematics)
Here is the mathematical formula for MRAR:
For the parameter γ = 2 (the standard value used by Morningstar when calculating MRAR):
What do the individual elements mean?
- γ (gamma) = 2
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What it is: The risk aversion level of the average investor
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In plain terms: “How much the average person dislikes unpredictability”
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Why 2: Studies show this is the optimal value for a typical retail investor
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- T = number of months
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In the example: T = 12 (year)
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In plain terms: “How many months of results are being analysed”
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- r_Gt = monthly excess return
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Formula: rGt = (1 + TRt)/(1 + Rbt) – 1
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In plain terms: “How much the fund outperformed a safe deposit in a given month”
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- Exponent (-2)
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In plain terms: This part “penalizes” unpredictability
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How it works: Large fluctuations are penalized
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- Exponent 6 (i.e. 12/γ)
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12: Converts monthly results to annual
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γ: Reflects level of risk aversion
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In plain terms: “Transforms the calculation back to an understandable annual percentage”
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Key Conclusions from the MRAR Formula
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MRAR “penalizes” unpredictability more than it rewards occasional strong outcomes
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The (-2) exponent means that losses “hurt” mathematically more than gains provide joy
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The closer MRAR is to the actual return, the more stable the fund was
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Stability has value—even if average returns are identical
Examples of Various MRAR Values and Their Interpretation
Example 1: Comparing two funds with identical returns but different risk
| Month | Fund A | Fund B |
|---|---|---|
| January | 0.50% | 0.10% |
| February | 1.00% | 2.00% |
| March | 0.50% | -0.90% |
| April | 1.00% | 0.50% |
| May | 0.50% | 3.82% |
| … | … | … |
| Cumulative Return | 9.38% | 9.38% |
| MRAR(2) | 9.37% | 9.10% |
Interpretation in plain language:
- Both funds earned exactly the same: 9.38% during the year
- Fund A received MRAR 9.37%—almost identical to its return, because it was very stable
- Fund B received MRAR 9.10%—0.27% lower due to performance variability
What does this mean in practice? Fund B had to “pay a penalty” of 0.27% per year for unpredictability. The average investor would prefer a guaranteed 9.10% per year rather than take a risk with this volatile fund.
Example 2: Typical MRAR Ranges in Different Fund Categories
MRAR for equity funds (growth categories)
| MRAR Value | Interpretation | Example Situation |
|---|---|---|
| 15%+ | Exceptional result | Top growth funds in good years |
| 10-15% | Very good result | Solid equity funds in the long term |
| 5-10% | Average result | Typical for equity ETFs |
| 0-5% | Weaker result | Barely above the risk-free rate |
| Negative | Very weak | Worse than a safe deposit |
Thanks to the star-based rating, you don’t have to delve into the details—just look at the final result (number of stars).
Summary and Conclusion
Morningstar stars are an intuitive filter based on solid mathematical foundations. This seemingly simple choice reflects the true risk aversion of the average retail investor and makes the rating system practical and useful.
Key advantages of the Morningstar rating system:
- Objectivity – the assessment is based on hard data, not opinions
- Realistic approach to risk – the rating calculation parameters reflect the preferences of typical investors
- Adjusted for risk and costs – funds with steady gains are rewarded
- Up to date – the rating is refreshed every month
However, even five stars do not guarantee future success. Treat the rating as a first step in your analysis—a signal to look more closely at the strategy, portfolio, and whether the fund suits your own investment goals.
Want to dive deeper into the details? The full methodology (in English) is available here: Morningstar Rating™ for Funds Methodology – PDF
