A Morningstar star rating is the measure of the risk-adjusted return of a fund relative to other funds in the same category, explains About.com. Fund ratings range from one to five stars, with the top performers receiving five stars.
The calculation of the risk-adjusted return occurs by taking the risk penalty of each fund and subtracting it from the total fund return after accounting for sales charges, loads and redemption fees, About.com advises. Ranking of the funds begins with the top 10 percent getting five stars, the next 22.5 percent receiving four stars and the middle 35 percent earning three stars. The following 22.5 percent gets two stars, and the bottom 10 percent receives one star.
The star rating shows the adjusted past performance for the market risk of a fund, according to About.com. For instance, a fund that has a low risk with high returns over time receives four or five stars, but a fund with high risk and low returns over time usually gets one or two stars. The main issue with this rating is that past performance is not always a good indicator of future performance. In fact, it's possible for many one- or two-star funds to perform extremely well in the future and four- or five-star funds to perform poorly.