The Big Screen: Intriguing One- and Two-Star Funds

While a one-star restaurant could give you indigestion and a two-star hotel might put you on a lumpy mattress, it's not necessarily a good idea to write off a fund just because it's saddled with a lowly one- or two-star rating on Morningstar's five-star scale.

Many investors seek out funds with four- and five-star ratings because they seem like a convenient seal of approval that winnows the thousands of funds to relatively few choices that often boast fat returns. But the star rating, in and of itself, isn't necessarily the best guidepost, since funds in hotter areas tend to be favored.

To prove our modest point, this week The Big Screen sifts the hundreds of nonsector U.S. stock funds with a one- or two-star rating for those that beat their average peer since Jan. 1 and over the last three years. To make our list, a fund also had to have below-average expenses and a manager who'd been in place for at least three years. Here are the top 10, ranked by their year-to-date return.

Star Quality These funds have lackluster Morningstar "star" ratings, but have trounced their peers over the past three years.
Fund	YTD Return	3-Year Annualized Return	Star Rating
(NALFX Quote)New Alternatives	73.3%	19.1%	**
SG Cowen Income+Growth	30.6	10.2	**
(ARSTX Quote)Mercantile Small Cap Equity	25.4	8.9	*
(VLSCX Quote)Value Line Emerging Opportunities	21.2	23.7	**
(STRGX Quote)Stratton Growth	19.8	8.9	**
(WSBEX Quote)Wright Selected Blue Chip	18.3	9.2	**
(HLDEX Quote)One Group Mid Cap Value	17.9	9.9	**
(FSLSX Quote)Fidelity Advisor Value Strategies	14.1	9.5	**
(COPLX Quote)Copley	13.1	10.2	**
(BRSIX Quote)Bridgeway Ultra-Small Index	11.5	8.8	**
S&P 500	-0.6	16.5	N/A
Source: Morningstar. Performance figures through Sept. 28.

If these fairly obscure funds have been beating their peers, why the low ratings? Mainly because they're in categories far from all the frothy action in large-cap growth stocks. Because the star rating lumps all U.S. domestic funds together -- comparing risk-adjusted returns for tech funds with mid-cap value funds, for instance -- and gives the top third a four- or five-star rating, those categories with the wind at their back tend to get all the stars.

The rating is based on a fund's risk-adjusted returns over the past one-, three-, five- and 10-year periods. Over the last few years, funds focusing on big-cap growth stocks have been in the sweet spot of the market, and it's no coincidence that nearly 60% of the large-cap growth funds had a four- or five-star rating at the end of August. Conversely, just three of the 125 small-cap value funds boasted the coveted four- or five-star ratings.

The bias can be even more pronounced for fixed-income funds. Just a couple of years ago, more than 90% of high-yield bond funds had a four- or five-star rating.

"I think it's important to remember the limitations of the star rating. When you have a wide disparity within an asset class, you can have a bias. In this case, large and tech-heavy funds have a bias over small and tech-light funds," said Morningstar's director of fund analysis, Russel Kinnel.

Morningstar has consistently noted the rating's flaws and urged investors to use its category rating, which measures funds' risk-adjusted returns vs. their more specific peers, in their fund shopping. In a speech at Morningstar's annual investment conference two years ago, even Chief Executive Don Phillips noted that many one- and two-star funds can be great additions to an investor's portfolio.

As you might imagine, most of the funds on our list focus on small- and/or mid-cap stocks, which lagged large-caps until last year. Maybe the most eye-catching fund is chart-topper, broker-sold (NALFX Quote)New Alternatives, which has a two-star rating despite a 73.3% return this year and a 19.1% three-year annualized return that beats the S&P 500.

The quirky small-cap blend fund's concentrated portfolio got a real boost from alternative power stocks like top holding Fuelcell Energy and top-10 pick AstroPower, up 656% and 201%, respectively, since Jan. 1. The fund, which TheStreet.com will profile next week, might be too odd to work as the small-cap holding in many investors' portfolios.

Other, more diversified small-cap funds on the list might be worth consideration though. These include (ARSTX Quote)Mercantile Small Cap Equity, (VLSCX Quote)Value Line Emerging Opportunities and (BRSIX Quote)Bridgeway Ultra-Small Index. Keep in mind that many of these lean toward value stocks that kept them from getting more stars.

There's also (FSLSX Quote)Fidelity Advisor Value Strategies, one of the few recognizable names on our list, where manager Harris Leviton blends small-cap growth and value stocks.

You'll also find some mid-cap possibilities on the list, like SG Cowen Income+Growth, (WSBEX Quote)Wright Selected Blue Chip, (COPLX Quote)Copley and (HLDEX Quote)One Group Mid Cap Value. And there's a large-cap fund on our list, (STRGX Quote)Stratton Growth, which despite its name is a large-cap value fund, according to Morningstar.

If small-cap or value stocks were more in favor in recent years, the tables would be turned and these funds would be the ones sporting top star ratings. The upshot for asset allocator types: Truly diversified portfolios might contain one or two funds that have only one or two stars.