By Jamie Dlugosch of Investor Place
The mutual fund industry is crowded and complex. With literally thousands of funds to choose from, no wonder investors can become confused.
Helping to sort out that confusion is
The rating agency dominates the landscape of those monitoring the mutual fund market, and its simple five-star ratings system has become the gold standard with respect to evaluating mutual funds.
Morningstar uses a formula of long-term and short-term performance adjusted for risk and expenses to determine its rankings. Five stars is the highest rating and one star is the lowest.
Going further, Morningstar has cleverly placed funds into what it calls style boxes that slice and dice funds based on size and investment approach. Investors can take the combination of the ratings and style boxes to help make investment decisions.
THE FLIP SIDE
It sounds rather simple, and we should all be thankful Morningstar has gone through such efforts to sort through such a complex maze for investors.
But ... hold on one second.
While there is much good to be said about Morningstar and its rating system, there is danger lurking in any attempt to make the complex so simple.
As everyone should know by now, past performance does not guarantee future success. In fact, one could argue that the very use of past performance as a way to rank funds looking forward is a mistake. If anything, a highly rated fund may not be able to sustain the types of returns that made it highly rated in the first place.
Prudent investors may want to lock in gains by selling highly rated funds instead of buying more shares as the high rating would suggest you do.
The flip side of that equation is true as well. Investors looking for an edge may wish to consider owning a fund that is poorly rated with the idea being that, in the future, superior performance is just around the corner.
Think of it as a contrarian approach.
Mutual funds can perform poorly for any number of reasons, and Morningstar's ranking system does not take out such noise.
For example, a mutual fund's style can be out of favor for such a period that the Morningstar rating will drop significantly as a result.
By the time the style becomes vogue, Morningstar would have you believe the fund is a dog. That is simply not true.
Do you remember how poor value managers fared in the 1990s during the technology bubble? The entire industry, including the pundits, claimed the value approach was dead.
You could buy any number of one-star or two-star funds in the category that ultimately performed quite well for the first eight years of the new millennium.
Another example can be found in understanding what it takes to manage money in a complex market.
It is a difficult job with only a small percentage of funds able to beat the market on a regular basis. Within the years of fantastic performance it is perfectly plausible for a high-quality manager to stumble with one or two bad years. It happens. And when it does, there goes the Morningstar ranking.
If you looked simply at the ranking, you might end up jettisoning a perfectly good fund that may be on the brink of a breakout.
IN SEARCH OF THE BEATEN-DOWN FUND
As a contrarian, I like the idea of finding the beaten-down stock or fund. The approach has served me well over the years. Buying low-rated funds fits quite well with that philosophy.
Here are five low-rated funds to consider today.
Fidelity Leveraged Company Stock
This one-star-rated fund from the Fidelity family of mutual funds deserves better. A horrendous last year sank the rating of FLVCX, but take out that one outlier and you see a much different picture. The objective of the fund is to obtain capital appreciation by buying common stock of companies it defines as being leveraged. That means it buys companies that issue lower-quality debt. Well, it makes sense then that this fund would struggle during the worst financial crisis in our lifetime. Companies with lots of debt struggled with their stock values being decimated. These companies did worse than the overall market. Interestingly, if you look at the chart provided by Morningstar, you will find a fund that over the past 10 years greatly outperformed its peers and the overall market. If you believe in the stabilization of the economy and a recovery from the depths of a near recession, my bet would be on this fund.
Al Frank Fund
I have some inside pool on this relatively small offering from Al Frank Asset Management. At the turn of the millennium I led a buyout of the management company that runs the fund and subsequently ran the company for two years. In all my due diligence and experience operating the company I understood one thing: This particular approach to the market had phenomenal performance about every five years of so. In the eyes of Morningstar, VALUX is rated a two-star fund, since the last year of huge performance for the fund came in 2004. But click on a 10-year chart and you will see a different story. This fund is overdue for a breakout year.
Manning & Napier Small Cap Fund
With only $171 million in assets, MNSMX can get whipsawed in a hurry. That's what happened when the market crashed and shares of this fund dropped in value -- like a rock. Morningstar rates the fund one star given its performance over the past two years or so, but there is more to the story. Looking at the 10-year track record shows that this fund performed above the market and its peers. With a few years of underperformance, the fund may be poised to return to greatness. In this case I would suggest that the underperformance has more to do with style issues than management issues. Small-cap stocks have been crushed in the bear market. They are only starting to recover. The time to buy this fund is now, when the rating agency thinks the least of its prospects.
CGM Focus Fund
Even funds with superstar managers can find themselves with low ratings after one or two years of poor performance. Ken Heebner is the manager of CGMFX, and his reputation is impeccable, but nobody is perfect. His fund has lagged the market going on two years or more. That's enough to get Morningstar to rate the fund with two stars. For much of the past decade, this particular fund was far superior to anything else available. Its performance during that time was stunning. It is only natural for there to be some sort of correction, and that correction is taking place right now. Again, would you buy this fund in 2006 with all cylinders firing and a five-star rating in place, or now, when things are a bit choppy and the rating is down to two stars? There can be no question: I would buy the fund now. Good managers do not simply stop being good managers.
Aberdeen Equity Long/Short
In the case of new funds, Morningstar likes to employ projections with respect to performance and ratings. For a long/short fund such as AELSX, that approach can be a bit unfair. As a fund that goes long and short, the objective of Aberdeen is to make money in up or down markets. They have been doing that since inception last year even if that performance is only slightly positive. Projecting returns forward for this fund, then, suggests middling performance at best. Perhaps that explains why Morningstar rates this fund with two stars. New funds are difficult to rate by nature, and in the case of Aberdeen I wouldn't even try. I like how this fund has gotten off to a good start beating its index handily and, in my opinion, investors can safely ignore the two-star designation.
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Dlugosch is the editor of Penny Stock Winners. He has over 20 years of experience in financial markets including investment banking, equity analysis and research and money management. In addition to being the Editor of Penny Stock Winners, he is also a Contributing Editor of InvestorPlace.com and founder and editor of The Rational Investor.