You may recall that Morningstar launched its “Star Rating” for hedge funds last month.  Given the myriad of differences between hedge funds and mutual funds (non-normality, illiquidity etc.), you may have been a little skeptical that the firm’s methodology was well suited to alternative investments.  We certainly were.  But it appears from recent academic research that the Morningstar Risk Adjusted Rating for mutual funds is actually a pretty flexible methodology for rating both mutual funds and hedge funds since it is “manipulation proof”.

This likely comes as no surprise to Morningstar itself, which said in a recent press release:

“The risk-adjusted return calculation and rating address two issues that are specific to hedge funds. First, unlike many other risk-adjusted performance measures such as the Sharpe ratio, the Morningstar hedge fund rating does not assume that funds have returns that follow the normal bell curve distribution. Second, the rating addresses the fact that some hedge funds invest in illiquid securities that are infrequently priced.”

While previous versions of its mutual fund rating system had “characteristics similar to those of an expected utility function” (see this paper by Sharpe in 1998), Morningstar revamped it in 2002 to include the asymmetrical utility of gains and losses experienced by investors (download PDF of the methodology).

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