What the Tables’ Numbers Will Tell You
If you look closely, you’ll notice something different about today’s special quarter-end mutual fund tables.
We changed the format and the way we categorize the “best-performing” funds. (We’ll explain that further down.)
To a casual observer, of course, the most striking difference is that most of the performance numbers have gotten smaller--much smaller. And we’re not referring to the size of the type.
The average U.S. diversified stock fund fell 15.2% in the quarter ended Sept. 30, according to independent fund-tracking firm Morningstar Inc. That ranks as the worst performance in eight years.
Clearly, the days when even less-than-diligent research could net you a high-performing fund portfolio are over. Doing your homework is more important now than ever--and that’s where our special tables can help.
Rationales Behind the Ratings
First, notice that our list of top-performing funds, starting on the previous page, isn’t composed simply of those that did best in the third quarter. Some funds that made the cut, like small growth fund Baron Asset, lost nearly a quarter of their value in the quarter.
Because short-term performance numbers can be deceptive, these tables highlight the best-performing funds over the three years through Sept. 30, factoring in both return and risk.
To compile this list, Morningstar started with its proprietary “category rating” system (which is not to be confused with its famous “star-rating” system).
These category ratings, which you’ll see as the first column of each table, assess a fund’s risk-adjusted performance over the last three years relative to other funds in its category. The ratings are 1 to 5, with 5 being the best.
For instance, take a look at the Large Growth category. You’ll notice that Janus Twenty, the first fund in this table, scores a category rating of 5. This means Morningstar considered this fund one of the best in risk-adjusted returns over the three-year period among those that invest in large domestic growth stocks.
At the same time, Provident Investment Counsel Growth scored a 3, which puts it around the middle of the pack in risk-adjusted performance in its category.
What does “risk-adjusted” mean? Morningstar judges each fund’s overall performance against its downside volatility. The idea is that you don’t necessarily want to earn the highest returns if a fund also is extremely volatile along the way. Morningstar believes consistency, as well as above-average performance, is also key in judging returns.
Raw performance still matters, of course, so the second column in each table ranks the funds by total return over the last three years, expressed by the percentile in which their performance appears within the category (1-100, with 1 being the top performers).
Finally, the third column is the familiar Morningstar three-year star rating, on a scale of 1 to 5, with 5 being the best.
As with the category ratings, the star ratings are handed out on a “bell curve”: The highest-rated 10% of funds get a 5, the next 22.5% get a 4, the next 35% get a 3, the next 22.5% get a 4 and the final 10% get a 1.
Category Rating vs. Star Rating
What’s the difference between the category rating and the star rating? In awarding stars, Morningstar compares funds not against others in their specific categories, but rather against others in one of just four much broader groupings: domestic stock funds, international stock funds, taxable bond funds and tax-free bond funds.
What this means, in effect, is that specific categories of funds that are of out of favor in a given period will tend have more funds with lower star ratings. And, conversely, funds in categories that investors have favored lately will tend to have more funds with higher star ratings.
For instance, take a look at the table showing the best-performing Diversified Emerging Markets Funds, on C14. You’ll notice that even the best-performing fund in this category scored only 3 stars. And the rest scored just 2.
Why? Emerging-market stocks have been out of favor for much of the last few years. European stock markets, by contrast, have performed well. So within the broad category of international stocks, several European stock funds get 5 stars from Morningstar, while no emerging-market funds come close.
So if you are specifically interested in emerging-market stock funds, the category rating may be more valuable than the star rating, because the former tells you which funds have performed best in that specific category.
Why even bother with the stars, then? Because in a poorly performing category, a star rating can confirm the overall quality of a fund.
For instance, look at the Mid-Cap Growth category, which has suffered recently. Note that 17 funds in this list received category ratings of 5. That means these funds delivered greater returns at less risk, in general, than did their peers.
But although most of them received only 2 or 3 stars, Oak Value, the second fund in the table, was awarded 5 stars.
What does this tell you? Remember, the stars are a reflection of how well a fund has done in terms of risk and returns versus a much broader category of funds--in this case, all domestic equity funds. If you look at Oak Value’s third-quarter, year-to-date and three-year performance numbers, you’ll find that they look fairly similar to those of the other funds in this table.
That means the greater number of stars probably speak to the fund’s risk--i.e., that the fund must not only be significantly less risky than other mid-cap growth funds, but also that it must be significantly less risky than domestic stock funds in general.
Indeed, with a bit of homework, you’ll find that Morningstar considers Oak Value 31% less risky than the typical domestic stock fund. By comparison, Morningstar says Delaware A Aggressive Growth, the top fund listed in this table, is 83% more risky.
Judging Returns Over Short Term
It’s an investing axiom that short-term returns by themselves can be misleading, but they can certainly play a role in decision-making if used properly.
For example, take a look at the Small Growth category and notice Aim A Aggressive Growth, which appears toward the bottom of the list. This fund, which invests in small growth companies, lost nearly 23% in the third quarter, slightly more than was average for its peers. Uh-oh.
Whether you are already in this fund and wondering whether you should sell, or whether you think small-cap stocks could rebound in the future and you’re wondering if this is a fund to buy, short-term under-performance should at least motivate you to investigate the fund further.
Go across that row to see how the fund has performed year-to-date and on a three-year annualized basis: You’ll see that Aim Aggressive Growth is down 16.2% year-to-date, which is more than the 15.9% loss that was average for the category. Hmmmm.
On a three-year annualized basis, the fund is up 1.8%, but the category average is a 3.1% gain. This, too, should give you pause.
There are other things to look for in evaluating individual funds. How long has the current manager been running the fund? We show that in the column labeled “Mngr Tnr,” for manager tenure (expressed in years).
Also check out fees. Our tables of the best-performing funds show fund fees in the column labeled “Exp Ratio,” for annual fund expenses as a percentage of assets. The average domestic stock fund has an annual expense ratio of 1.4%.
Keep in mind, though, that some types of funds are more costly to manage than others. For instance, the staffing needed to properly research obscure emerging-market stocks is likely to be greater than that required for a fund investing in well-known companies here at home.
On the far right side of each table is a very useful column labeled “Worst 3 mos.”
You’ll often hear financial planners advise investors to consider how much they’d be willing to lose on a fund. Would you be willing to hold on to a fund even if its value plunges, say, 33%? What about 50%?
If you want a fund that will let you sleep well at night, you may want to peruse this column to see how much the funds you own--or want to invest in--have lost in their worst three-month period. This figure is no guarantee of future performance, of course. Any fund could very well lose more--or less--over some other three months in the future.
However, the differences among worst-three-month figures can be considerable. For instance, in the Intermediate Government Bond category, Monitor Mortgage Securities fell 19.7% in its worst three-month period. But Parkstone Government Income lost just 2.2% over its worst three months.
Finally, as you’re reading the A-to-Z fund tables on C16 to C18, you might find that some lack a category ranking. The Dreyfus fund is an example.
Is it because the fund hasn’t been around for more than three years? No. Dreyfus has been around since 1951. What happens sometimes is that Morningstar will re-categorize a fund, based on its evaluation of the fund’s holdings. Dreyfus, for instance, is currently listed as a Large-Cap Value fund. However, in 1997, Morningstar had it in a mid-cap category, thus preventing Morningstar from being able to give this fund a three-year large-cap-value category rating. However, because Morningstar’s star-rating system judges funds in one of four broad classes, this fund does get a star rating, 2 in this case.
