A Guide to Using Morningstar’s Data on Top-Rated Funds

Our tables on these pages are designed to help you pick new mutual funds and assess the performance of funds you already own.

As with selecting a good diamond, there’s a system you can use to find good funds.

Instead of the four Cs--cut, carat, color and clarity--fund investors must consider the four Rs: returns, ratings, risk and ratio of expenses to assets.

Our lists of funds on these pages are fund tracker Morningstar Inc.’s top-rated funds, according to its proprietary rating system.

Here’s an explanation of the four Rs and how these funds come to be ranked highest by Morningstar:

* Returns. Obviously, before selecting a mutual fund, you’ll want to look at its track record. Past performance isn’t a guarantee of future returns, but it can be an indication of competence and consistency.

Performance-return figures are simple to look up in our charts. Under the header “Total % Return” you’ll see three figures.

The first shows the fund’s return in the fourth quarter (Sept. 29 to Dec. 29). The second shows the return for all of 2000.

The third shows the fund’s annualized return over the three years ended Dec. 29. In other words, it takes the fund’s total three-year net return and calculates what that worked out to on an annualized basis.

By comparing each fund’s return with its category average for any given period, you can see whether the fund did better or worse than the average fund.

There’s another way to measure longer-term performance. Look at the second column in each table--the “3-yr Rnk” column.

This shows how a fund ranks by return over the last three years, expressed in percentiles. A “1” rank means a fund ranked in the first percentile in its category; a “99” means the fund ranked at the bottom of its category.

* Ratings and Risk. These two Rs are intertwined, based on the different rating systems that Morningstar uses to judge funds against their peers.

“Category ratings,” which you’ll see in the first column of each table as “Cat Rtg,” assess a fund’s “risk-adjusted” performance over the last three years relative to other funds in its specific category.

The ratings are from 1 to 5, with 5 being best.

What does risk-adjusted mean? Morningstar judges each fund’s overall performance against its downside volatility. The idea is that you don’t necessarily want to earn the highest returns if a fund also is extremely volatile, swinging wildly in terms of returns.

High volatility increases the chance of loss if you need to sell at a bad time.

So Morningstar believes that consistency of performance, as well as above-average performance, is important in judging returns--and whether a fund is a good choice for the typical investor.

You’re probably more familiar with the rating system shown in the third column of our tables--Morningstar’s famous three-year “star” rating (“3-yr Star” in the header), which also has a 1-to-5 scale, with 5 being the best.

As with the category ratings, the star ratings are handed out on a bell curve: The highest-rated 10% of funds get a 5, the next 22.5% get a 4, the next 35% get a 3, the next 22.5% get a 4 and the lowest 10% get a 1.

What’s the real difference between the category rating and the star rating? In awarding stars, Morningstar compares a fund not with others in its specific category but with others in one of just four much broader fund groupings: domestic stock funds, international stock funds, taxable bond funds or tax-free bond funds.

What this means, in effect, is that specific categories of funds out of favor in a given period, relative to the broad market, will tend to have more funds with lower star ratings.

Conversely, funds in categories that investors have favored lately, relative to the broad market, will tend to have more funds with higher star ratings.

For instance, even the top-performing real-estate-stock funds mostly merit just two stars. That’s because the funds have been out of favor for most of the last few years, compared with other market sectors.

By contrast, as you might suspect, many technology stock funds get five stars.

The obvious problem with star ratings: They are backward-looking; they don’t necessarily tell you which fund categories may be starting to shine.

So if you’re interested in a real estate fund, the category rating in our tables might be more valuable than the star rating because the former tells you which funds have performed best in their specific category, rather than relative to the broad market.

* Ratio of expenses. Our tables show each fund’s management fees in the column labeled “Exp Ratio.” That measures annual fund expenses as a percentage of assets.

The average for each category is shown at the bottom of each table.

If a fund charges more than the average, it should be producing above-average returns for shareholders as well. If not, you should wonder what you’re paying for.

Keep in mind that some types of funds are more costly to manage than others. For instance, the staffing needed to properly research obscure emerging-markets stocks is likely to be greater than that required for a fund investing in well-known companies here at home. So judge a fund’s expense ratio relative to that of its peers.

Funds with sales charges, or “loads,” usually are sold by brokers or other financial advisors and often are a way to pay for advice.

The long-term effect of sales charges is an ongoing controversy, but it is important to note that return figures and Morningstar ratings do not take these sales charges into account.

* Other things to consider. On the far right side of each table is a column labeled “Worst 3 mos.” That shows each fund’s worst three-month loss within the last five years.

You’ll often hear financial planners advise investors to consider how much they’d be willing to lose in a fund. Would you be willing to hold on to a fund even if its value plunged 33%? What about 50%?

If you want a fund that will let you sleep well at night, you might want to peruse this column to see how much each of the funds you own--or want to invest in--has lost in its worst three-month period. (This figure is no guarantee of future performance, of course.)

Finally, the column “Mngr Tnr” in our tables shows how many years a fund’s current manager has been running the portfolio. That can be another indication of a fund’s consistency, although even veteran managers can hit dry spells.