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The Short Answer

Find Hidden Fund Gems

By David Kathman, CFA | 12-12-06 | 06:00 AM

Back in October, we took a look at some of the pluses and minuses of
the Morningstar Rating for funds, better known as the star rating.
That rating is well known as a quick way to evaluate a fund's
risk-adjusted performance relative to its peers, but it doesn't always
tell the whole story. Some funds with high star ratings are less
attractive than they might appear at first glance, usually because the
manager responsible for good past performance has left or because
the fund occupies a hot niche that has temporarily inflated
performance.
Just as a high star rating is no guarantee of a good fund, the opposite
is also true. A low star rating does not necessarily mean a fund is bad;
in fact, there are plenty of very good funds out there that sport 1 or 2
stars, including quite a few Fund Analyst Picks. Someone who
automatically excluded funds for having a low star rating would be
missing out on some real winners. Looking beyond the usual 4- and
5-star suspects can reveal some excellent funds that don't deserve to
be overlooked.
Positive Manager Changes
In our earlier column, we noted that a high star rating and good
long-term track record don't mean much if the manager responsible
for that record has recently left. The opposite is also true: A low star
rating and poor long-term record don't matter if the managers behind
that record are gone. Such a fund can actually be quite attractive if
the new manager has a strong record elsewhere, or has put together
good results since taking over.
For example, consider FPA Paramount FPRAX . This fund has a
Morningstar rating of 2 stars, mainly because of a terrible 10-year
record that ranks in the bottom 5% of mid-cap blend funds. However,
since current managers Erik Ende and Steven Geist took over the fund
in March 2000, it has looked much better, finishing in the category's
top quartile four times and beating its peers over the trailing five
years. The same managers have compiled an excellent record at the
similar FPA Perennial FPPFX since 1995. For all these reasons, plus
a big tax-loss carryforward left over from before Ende and Geist took
over, FPA Paramount is an Analyst Pick in the mid-cap blend category
despite its 2-star rating.
USAA Aggressive Growth USAUX is a similar example. Like FPA
Paramount, it's an Analyst Pick (in the large-growth category) even

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though it has a rating of 2 stars and poor 10-year relative returns. In

this case, the manager is Tom Marsico, who began subadvising the
fund in mid-2002 after dismal results from previous management.
Marsico has built one of the best long-term records of any
large-growth manager; he managed Janus Twenty from 1988 to
1997, and since starting his own shop he has guided Marsico Growth
MGRIX and Marsico Focus MFOCX to great returns and 5-star ratings.
Since he took over, this fund has consistently beaten its category, and
we just recently made it a large-growth Analyst Pick--replacing
Marsico Focus, which has slightly higher expenses.
Steady Funds in Hot Categories
When a category has been hot for several years, disconnects can arise
between the quality of funds in that category and their star ratings.
In our earlier column, we showed how an ultra-risky fund such as
Jacob Internet JAMFX can be an Analyst Pan despite a 5-star rating,
if flashy short-term results don't look sustainable. The flip side is
when an attractive, relatively stable fund with good long-term
prospects underperforms its flashier peers for a few years, resulting
in a low star rating.
One good example is American Funds New World NEWFX , which is
an Analyst Pick in the diversified emerging-markets category despite
its current 1-star rating. This fund combines direct emerging-markets
exposure with indirect exposure through U.S., European, and
Japanese stocks that get a lot of their earnings from emerging
markets. These developed-market stocks have kept the fund's
volatility low relative to its category peers, and experienced
managers and low expenses make it even more attractive for the long
term. However, the riskiest emerging-markets stocks have been on
fire the past five years, and this fund has not been able to keep up
with pure-play emerging-market peers during that time, even on a
risk-adjusted basis. It doesn't help that this fund doesn't yet have a
10-year record, so its star rating is based entirely on its three- and
five-year records, and its top-decile returns in 2000 are not included.
A similar story surrounds American Century Global Gold BGEIX , a
2-star Analyst Pick in the precious metals category. The fund focuses
on stocks of large, diversified gold producers, mostly avoiding
smaller, less-diversified companies that are more directly sensitive to
gold prices. That has not been a particularly good place to be as gold
prices have gone up in recent years, so the fund has trailed its peers.
However, it's a good, solid way to get gold exposure over the long
run, and an experienced manager (in place since 1992) and low
expenses are icing on the cake.
When Returns Aren't the Focus
Finally, the star rating can be somewhat misleading in certain
categories where stability and low costs tend to be just as important

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as returns. For example, both of our Analyst Picks in the new bank
loan category currently feature low star ratings: Eaton Vance
Floating Rate EVBLX has one star, while Fidelity Floating Rate High
Income FFRHX has two. Neither fund has particularly high
risk-adjusted returns relative to the rest of the category, but we like
them because of their low volatility and stable returns, as well as
experienced managers and the Fidelity fund's low expenses.
In the new target-date 2015-2029 category, we have six Analyst Picks,
including three T. Rowe Price funds and three Vanguard funds, with
target dates of 2015, 2020, and 2025. Because these are such new
funds, only three of them currently have star ratings; one of these,
Vanguard Target Retirement 2015 VTXVX , gets just 2 stars, mainly
because its 50% stock weighting has been lower than the 62% average
for the category. Another of these Picks, Vanguard Target
Retirement 2025 VTTVX , gets 3 stars. However, trailing returns are
much less important for such funds than their asset allocation
schemes, which will change over time by the nature of the funds, and
their costs. The Vanguard funds are among the cheapest in the
category, which is a big reason why they're Analyst Picks.
The examples we have looked at have all been Analyst Picks, and our
lists of picks in each category are a great way to identify the best
funds in a category, regardless of star ratings. However, there are
plenty of other good funds that are better than their star ratings
might lead you to believe at first glance. You'll need to do some
reasearch to find them, but knowing what to look for--recent
manager changes, hot categories--can make that task easier.

David Kathman, CFA, is a fund analyst with Morningstar.

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1/25/2007 2:59 PM