The Morningstar Rating for Funds is a proprietary system that assigns each mutual fund a rating from one to five stars based on the fund's historical performance in relation to similar funds, according to the Morningstar Investing Glossary. Funds are mathematically evaluated based on their three-year, five-year and ten-year performance. Ten percent of funds receive a five-star rating, 10 percent receive a one-star rating, and the remaining 80 percent receive a two-, three- or four-star rating.
Each fund's star rating depends on the fund's Morningstar Category, explains the Morningstar Investing Glossary. The category system is based on a fund's actual holdings, regardless of its stated objectives. Funds are compared only to those with similar holdings; for example, long-term bond funds are compared only to other long-term bond funds. Star ratings are evenly distributed within each category, so a five-star performance does not mean the same thing across different categories.
Morningstar only assigns star ratings to funds that have been active for at least three years. The company states that the ratings are intended to spur further research and do not indicate buy or sell ratings.
Media organizations such as U.S. News & World Report and NerdWallet have criticized Morningstar's ratings system, pointing out that a higher star rating offers no guarantee of future results. In fact, a Vanguard study found that funds with a one-star rating actually outperformed those with a five-star rating during the subsequent three-year period, according to NerdWallet.