A hotel might have four stars but still leave you with a lumpy mattress and a leaky faucet. The same holds true in the fund world.
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Good ratings give a fund a convenient seal of approval. The most recognized and popular are Morningstar's star ratings, which litter fund ads in every financial mag. Funds with four- and five-star ratings routinely capture our attention and the lion's share of fund sales -- but use them as your
yardstick and you might end up with a dud. The reason: The star rating system lumps funds of different styles together, so those whose styles happen to have a tail wind get the most stars, whether they execute that style well or not.
To prove our point, this week's Big Screen gives you the facts on the star system and digs up some four-star funds that don't excel among their true peers. Then we'll outline how you can use ratings as a more accurate divining rod and show you our shopping guide.
How does the star rating work? Essentially all the funds in a broad category, like domestic stock funds or taxable bond funds, are tossed into a pot and ranked by their risk-adjusted returns over the past one, three, five and 10 years. For each time period, a fund is given a star rating from one to five. The top 10% get a five-star rating and the next 22.5% get a four-star rating.
The problem is that this approach stacks up funds with disparate strategies, comparing tech funds with small-cap value funds, for instance. So whenever a given category is in vogue, its funds naturally rise to the top, while the solid funds whose style happens to be out of favor sink.
At the peak of the tech bubble in March 2000, for example, more than half of the nation's growth funds had a four- or five-star rating while just 4% of value funds earned the coveted rating. Now that the tech sector's collapse has dragged growth funds down, the tables have turned. Today, 45% of value funds carry four or five shiny stars next to their name, while just 21% of growth funds can say the same. Are all those value funds winners and are all those one- and two-star growth funds losers? Nope.
Naturally, many of the funds with top ratings are solid performers. But many also grab stars because the sun is beaming on their sector or style. Funds must be at least 3 years old to get a star rating, and of the 32 tech funds that cleared that bar in March 2000, 30 had a four- or five-star rating. With the average tech fund down some 60% over the past 12 months, we can safely say they weren't all winners.
The same trend, to a more modest degree, is blooming in the value-fund ranks, particularly among small- and mid-cap value funds that have best survived the past 18 months of losses. We sifted the small- and mid-cap value packs for four- or five-star ratings that are trailing at least 80% of their true peers over the past three years. Here is a top-10 list, sorted by their rankings in the small- and mid-cap value categories.
Now, some of the funds on this list are still worth a look despite their less than flattering rankings over the past three years.
The mid-cap value
Oakmark fund is only on the list because former manager Robert Sanborn, who stopped by this week for a
chat, struggled mightily in 1999's tech froth. Current manager Bill Nygren has steered the fund to a 29.2% gain over the past 12 months, topping 97% of his competitors and beating the
by more than 47 percentage points. His enviable record on the now-closed
Oakmark Select shows this streak isn't a fluke.
A solid small-cap value fund on the list is suffering from a lousy 1999, too: the
Royce Special Equity fund, run by Charles Dreifus. He's righted the fund over the past 12 months, beating more than 90% of his peers.
Others are struggling despite their star ratings. The
Skyline Special Equities fund, run by Bill Dutton, floundered in 1999 like many value funds but is about flat so far this year. It trails more than 70% of the other small-cap value funds. Dutton has earned a reputation as a solid small-cap specialist, but his fund lags its average competitor over the past one, three and five years, according to Morningstar. The same goes for the
Prudential Value fund.
Keep in mind this trend happens among bond funds, too. Short-term bond funds have had a nice run, and 88 of the 118 out there have a four- or five-star rating. That includes the
GMO Short-Term Income fund, which has five stars even though it trails at least 70% of its peers over the past one, three, five and 10 years.
Morningstar has broadened its menu of fund ratings to cover the star system's blind spots. The category rating uses a similar methodology and ranks funds from one to five, but against their true peers -- tech funds vs. tech funds, rather than lumping disparate funds together. They also have "analyst picks" for each category for which a given analyst singles out five of fewer funds that are his favorites in a particular style.
Complicating matters, you'll also see rankings or endorsements from a host of other shops, including Lipper and Standard & Poor's. Each rating system slices the fund world differently, and none should be the sole driver of your decision-making. How can you avoid buying a four- or five-star loser? The short answer is to look beyond ratings and do your own legwork.
You're typically better served by spreading your money among a diversified range of categories, screening each for funds that have consistently topped their peers with low-risk scores, low expenses and a tenured manager who owns the track record you like so much. Once you've done that, you can check out the surviving funds' ratings.
In our own way, we've tried to help you out, though without slapping stars or other labels on any funds. Each week the Big Screen sifts a given fund pack for solid choices. We've pulled them all together in this
archive, along with a blueprint of a diversified portfolio.
Ian McDonald writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to
firstname.lastname@example.org, but he cannot give specific financial advice.