Evaluating Mutual Fund Performance
Picking new mutual funds, or assessing the ones you already own, isn’t as difficult as all the numbers on this page might imply. Really.
These pages are organized to simplify your efforts.
How? As with selecting a good diamond, there’s a system you can use to find good funds. Instead of the four Cs--cut, carat, color and clarity--fund investors must consider the four Rs: returns, ratings, risk and (expense) ratio. (OK, it’s really three Rs and an E.)
Our lists of funds, compiled by fund tracker Morningstar Inc., provide information on these characteristics.
* Let’s start with returns.
Obviously, before selecting a mutual fund, you’ll want to look at its track record. Past performance isn’t a guarantee of future returns, but it can be an indication of competence and consistency.
Performance return figures are simple to look up in our charts. For instance, look on the opposite page, S12, in the right-hand column, at the “small growth” category. The first fund on this chart is RS Emerging Growth. Go four columns to the right and you’ll note that in the third quarter of 1999, this fund generated 7.8% in total returns (share price appreciation plus dividend yield). Now go one more column to the right; you’ll see that year to date, the fund is up a staggering 61.3%.
Obviously, just by looking at these returns, you can tell that this fund has been doing extremely well recently. But for the sake of argument, let’s say the numbers were considerably lower. How could you tell if this fund, on the basis of its returns, were better than average?
Take your finger and place it on the year-to-date total return figure for RS Emerging Growth. Now go all the way down the column to the bottom of the chart. There you’ll find that the average small growth stock fund--that is, funds that invest in the type of stocks this fund buys--generated a total return of 14.8% in the first nine months of the calendar year. Clearly, RS Emerging Growth did considerably better.
This section uses year-to-date returns as a near-term performance period instead of one-year returns. This is because in last year’s third quarter, the stock market entered into a severe (but short-term) slide prompted by fears about the global financial crisis. Thus, many stock funds are now posting unusually large--and anomalous--one-year total-return figures. This is particularly dramatic for a few funds. (For instance, over the last year, Nicholas-Applegate Global Technology is up 478.3%. Firsthand Technology Innovators is up 298.4%.) As a result, analysts warn investors not to rely too much on current one-year numbers to judge--or to establish expectations for--their funds. Also, be aware that advertisements using one-year numbers might be particularly impressive in coming weeks.
After noting short-term performance, check the next column. Financial planners advise clients to look at long-term performance numbers. To help you do that, we’ve provided three-year annualized return figures for all of the funds in our tables. You can see that RS Emerging Growth has also beaten its peers during the last three years--in fact, it’s done nearly four times as well.
There’s another way to look up long-term performance. Look at the second column in each table. It ranks funds by total return over the last three years, expressed by the percentile in which their performance ranks within the category (1 to 100, with 1 being the top performers). RS Emerging Growth’s “1” score indicates this fund beat 99% of its peers over the last three years.
* Next let’s turn to fund ratings.
Here, we’re talking about the different rating systems that Morningstar uses to judge funds against their peers.
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 small value category at the bottom left corner of this page. You’ll notice that Berger Small Cap Value, the first fund in this table, scored 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 value-oriented funds that invest in small-company stocks.
Dreyfus Small Company Value, however, scored a 3, which puts it in 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. High volatility increases the chance of loss if you need to sell at a bad time.
So Morningstar believes consistency of performance, as well as above-average performance, is important in judging returns--and whether a fund is a good choice for the typical investor. (In this sense, the third R in our system, risk, is folded into Morningstar’s ratings.)
You’re probably more familiar with the rating system shown in the third column of our tables--Morningstar’s famous three-year “star” rating, which also has a 1-to-5 scale, 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 lowest 10% get a 1.
What’s the real difference between the category rating and the star rating?
In awarding stars, Morningstar compares funds not with others in specific categories but with 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 specific categories of funds that are out of favor in a given period will tend to have more funds with lower star ratings. 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 on S15 showing the best-performing real estate funds. Even the top fund in this category scored only two stars. Why? Real estate investment trusts have been out of favor for a few years now.
By contrast, technology funds (also shown on S15) have performed well in the last decade. So within the broad category of technology sector funds, all of the tech funds that made our “top funds” list got five stars, whereas no real estate fund came close.
So if you are interested in a real estate fund, the category rating might be more valuable than the star rating because the former tells you which funds have performed best in that category.
* Factor in costs.
Our tables show fund fees in the column labeled “Exp Ratio,” for annual fund expenses as a percentage of assets. The average for each category is shown at the bottom of each table.
If a fund charges more than the average, it should be producing above-average returns for shareholders as well. Keep in mind that some types of funds are more costly to manage than others. For instance, the staffing needed to properly research obscure emerging-markets stocks is likely to be greater than that required for a fund investing in well-known companies here at home. So judge a fund’s expense ratio relative to that of its peers.
Funds with sales charges, or “loads,” are usually sold by brokers or other financial advisors and are often a way to pay for advice. The long-term effect of sales charges are an ongoing controversy, but it is important to note that return figures and Morningstar ratings do not take these sales charges into account.
* Other things to consider.
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 in a fund. Would you be willing to hold on to a fund even if its value plunged 33%? What about 50%?
If you want a fund that will let you sleep well at night, you might want to peruse this column to see how much each of the funds you own--or want to invest in--has lost in its worst three-month period. (This figure is no guarantee of future performance, of course.)
The differences among these figures can be considerable. For instance, in the high-yield bond fund category (on S14), Fidelity Capital & Income lost 11.1% in its worst three-month period. However, Columbia High-Yield lost just 2.7% during its worst three-month stretch.
Another thing you’ll see in our tables, under “Mngr Tnr,” is how long each fund’s manager has been running the portfolio. That can be another indication of a fund’s consistency, although even veteran managers can hit dry spells.
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About Morningstar
Mutual fund information in this section and the tables on S12-15 are based on information from fund tracker Morningstar Inc.
Morningstar is a privately owned company founded in 1984 to provide investors with information from an independent source for use in making investment decisions. Its “star” rating system is used by financial planners, cited in advertisements and used as a guide by investors and the media.
As the Chicago-based company has grown, its staff of analysts, writers and programmers has introduced print and software products for individual and professional investors. These include the investor guides “Morningstar Mutual Funds”; “Morningstar FundInvestor”; “Morningstar StockInvestor”; CD-ROM “Morningstar Principia Pro Plus for Mutual Funds, Closed-End Funds, Stocks, and Variable Annuities/ Life”; and Morningstar’s Web site at https://www .morningstar.com.
To learn more about Morningstar and its products, call (800) 735-0700.
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Paul J. Lim can be reached at paul.lim@latimes.com.
