With Fund Ratings, Stars and Medals Both Matter

Russ Kinnel: You're welcome.

Benz: Russ, we often get this question--and we do have several different ratings systems--but for mutual funds we have the star rating and the Analyst Rating. Let's talk about the two rating systems, what they are meant to do and how they are different.

Kinnel: Yeah, there are some pretty big differences. So, if you think about it, the star rating is quantitative, the Analyst Rating is fundamental. The star rating covers the entire investment universe--virtually anything with a three-year record gets a star rating. The Analyst Rating is about 1,000 funds because we have a lot of intensive research involved. The star rating is looking back on the trailing three-, five-, and 10-year periods, risk-adjusting that performance and then telling you relative to the peer group how that shakes out.

The Analyst Rating is looking at fundamentals. We cover the five P's: People, Process, Parent, Performance, and Price. Look at all those elements because of course they are related. It's not silos. We look at all those things; we do research; we talk to the managers; we visit the fund companies; and come up with our forward-looking rating to say, here is what we think the fund's prospects are over the long haul for good risk-adjusted returns. Gold being the highest rating, Negative being the lowest. So, though there are some similar elements, there are really some very big differences in those two ratings.

Benz: OK. Though we have it, we have never held out the star rating as being predictive or forward-looking in the same way that we look to our Analyst Ratings to be.

Kinnel: That's right. The star rating gives you a good idea of where the fund has been. In the Analyst Rating we're attempting to tell you where we think it's headed.

Benz: OK. So, one of the things that can really confuse readers and users of Morningstar.com is when there's a disconnect. When you've got a fund with a high star rating, poor Analyst Rating or the opposite where it has a good Analyst Rating but poor recent returns. So, you brought some funds that you think illustrate this concept well. Let's start with Janus Balanced. This is a Neutrally rated fund that currently carries a 5-star rating. So, its performance has been really good relative to other funds in that 50% to 70% equity allocation peer group.

Kinnel: That's right. So, it has very good performance. But what's not in the star rating is manager information. We used to like this fund, but then Gibson Smith, who headed Janus' fixed-income side and was the co-manager of this fund, left the firm, and then we were left with a less experienced manager replacing him on the bond side. The equity manager, Marc Pinto, is someone who had an OK but not very impressive record at some pure equity funds at Janus. So, we put that together and we have a Neutral rating even though, as you know, performance has been very good, because of course a very important driver of that performance is no longer at Janus.

Benz: The manager who left?

Kinnel: That's right.

Benz: OK. Let's take a look at Fidelity Small Cap Value, also Neutrally rated. It's a small-cap value fund and it too has a 5-star rating. Kind of a similar situation with some manager changes over the past few years?

Kinnel: That's right. So, first, the fund was run by Chuck Myers, then handed to Derek Janssen. We really like Chuck. Now, Chuck Myers is leaving a different fund at Fidelity, so Derek Janssen is going to slowly be transitioning over to that fund and at this fund Janssen will be replaced by a manager who has no track record. He has an analyst at Fidelity. So, again, the long-term appeal of this fund has diminished. It's not that we don't like the new manager. It's just he hasn't established a track record. So, we recently lowered the fund's rating from Bronze to Neutral. Again, it's really a manager-driven story.

Benz: OK. Let's look at the opposite situation. This is actually the basket of funds that I often like to look at--the highly rated funds that have looked lousy in the recent past. I think it's kind of a good contrarian way to look at the world, and I want to get your take on whether that's an issue with these two funds as well.

The first one is Vanguard FTSE All-World Ex-US Small Cap Index. This is a Silver-rated fund that currently has just a 2-star rating. Let's talk about what's going on there, why its performance has been weak, and why the analyst team still has conviction.

Kinnel: That's right. So, it's an index fund focusing on foreign small-cap equities. It's got low costs, like you'd expect from Vanguard. It's a well-designed index. So, we see some really good fundamentals there; however, performance has not been great, but there is a good reason for that. The fund has a significantly higher weight in emerging markets. It's also got a fairly high weight in some of the developed Asia markets like Korea and Taiwan that tend to be underweight in that category. And those areas have done really poorly. But again, it's not like they were making a bet and they were wrong. It's just that's how the index has developed and therefore, you'd expect over the next few years markets rotate, and so it wouldn't at all be a surprise if emerging markets do well, that this fund would do well. But again, it's got all the things you look for in a good index fund, well-diversified, low-cost.

Benz: OK. This Vanguard fund, Russ, I know you like the fund, but would you say it's a core holding or would you relegate it to a smaller position in a broad portfolio?

Kinnel: Yeah, I see it more as a supporting player, because it is focused on foreign small caps. So, they are going to be more volatile than foreign large caps. I think it's a useful fund to have in your portfolio, but yeah, I would not call it a core holding.

Benz: Let's look at another fund, a world stock fund in this case, is Tweedy, Browne Worldwide High Dividend Yield Value. Let's talk about that fund. It has a Silver rating currently and a 1-star rating.

Kinnel: That's right. This fund, again, part of the story is regional. This fund has much less in the U.S. than its peer group and therefore--again, the U.S. has done really well recently. So, that's been a real drag on the fund and its five-year numbers are not good as illustrated by the star rating. The star rating--because it only looks at three, five, and 10--is missing, however, the fact that this fund has a nine-year record. So, those back four years are not in the star rating. If you look at the nine-year performance, it's decent, it's not great, but it's decent. But what we're really looking at is the fact that if you look at Tweedy, Browne's other funds, over the long haul they've done a very good job, so we know the managers, we know the process. This one has got a slight dividend-yield tilt versus the others, but it's the same core value selection process that gives us faith that this should be a good fund in the long run even though the last five years have not been great.

Benz: What about this overall idea of this as a contrarian strategy, that you kind of look for the medalists, but if you're looking for new holdings for your portfolio, maybe look at the ones that are a little bit down in the dumps from the standpoint of star ratings? Does that make sense to you?

Kinnel: Yeah, a little bit. I'm not sure I'd want an entire portfolio of those because I might end up with the same bets, right? But yeah, I think it's not a bad way to go. I think it's much better than doing the opposite of looking for the best returns. So, yeah, I think it means when you see that, what you were saying is, we think this fund has really good fundamentals but we acknowledge that performance has not been great. So, I do think it's a good contrarian way to invest. It's a good reminder, I think, that we don't want to get too caught up in recent performance because we can get caught leading the wrong direction when we do that.

Benz: OK. Russ, interesting thing to look at. Thank you for being here to clarify the difference between the star rating and the Analyst Rating.

Kinnel: You're welcome.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.