How to Tell if a ‘One-Star’ Mutual Fund May Be Headed for a Brighter Future

There are few things rarer in the world of mutual funds than a buy recommendation for a “one-star” fund.

Try to imagine a financial planner suggesting a fund with the lowest of the five ratings given by the Morningstar Inc. fund research firm. It sounds laughable.

But that’s precisely where we intend to venture today, prospecting for interesting specimens among the 10% of funds that have received Morningstar’s lowest rating for risk-adjusted returns over the last three years. (The Times lists Morningstar’s ratings for 4,000 funds every Sunday; see page C13.)

Funds that don’t earn five- or four-star ratings from Morningstar nowadays face a big problem. They can’t attract much new money, and they may be in for a struggle to keep the investors they have.

In the first 11 months of last year, according to Financial Research Corp. in Boston, funds that carried Morningstar’s five- and four-star ratings attracted $182 billion in net new cash inflows.

Over the same stretch, FRC says, a net $119 billion poured out of funds with one-, two- and three-star ratings.

Our purpose here isn’t to critique Morningstar’s system. The arguments about that have been going on for years, even as the star ratings have gained wide acceptance among investors and financial advisors.

Rather, our intent is to see what we could turn up in a corner of the marketplace where few people would look. After all, there must be some one-star funds that are on the way to higher ratings.

Morningstar takes pains to point out that the ratings are a mere starting point for investors; they contain no element of subjective judgment, but are purely mathematical measures of past performance adjusted for the risk the fund took.

A fund sector that had a terrible run--Asian funds in 1997 and 1998, for example--naturally would contain many low-rated funds.

“The star-rating groups are very broad, and a change in a fund’s star rating may simply reflect the fact that other areas of the market are outperforming” for the time being, Morningstar’s David Harrell says.

What’s key to remember is that a rating is a reflection of what has happened before. It doesn’t take into account that things may be about to change for a fund sector or an individual fund.

Some very well-known managers now run one-star funds. In most cases, they have stumbled with some bad market bets in recent years, after shining in previous years.

Among the funds rated one star as of Dec. 31, for example, are portfolios with such noted managers as Jean-Marie Eveillard (First Eagle SoGen Gold Fund), Dick Strong (Strong Discovery Fund), Bill Sams (FPA Paramount Fund), Donald Yacktman (Yacktman Fund) and Andrew Davis (Davis Real Estate Fund).

The question an investor needs to ask: Is there a reason to believe that these managers are retooling their funds for success again--or have the managers simply lost their touch, permanently?

Also rated one star: a prominent stock fund (Merrill Lynch Growth Fund) that has handily beaten the Standard & Poor’s 500 index since a new manager took over in early 1999.

With Stephen Silverman at the helm, Merrill Lynch Growth’s Class A shares have returned 35% in the last year, compared with a 12% gain for the S&P; 500. That’s a drastic reversal from 1998, when the fund lost 23%.

“This fund is on the comeback trail,” Morningstar analyst Kunal Kapoor wrote recently. But you wouldn’t yet know it from the star rating.

A better star rating will evidently have to wait until the end of 2001, after which 1998 will no longer count in the fund’s three-year performance.

Fidelity New Markets Income, which buys bonds from Latin America, Russia and similar credit frontiers, also merits just one star under the Morningstar system--even though the fund gained 35% last year, after diving in 1998. It’s also up year-to-date.

In this case, the one-star rating warns you about the fund’s extreme volatility. “The emerging markets aren’t worth the heartburn,” argues Brian Trumbore, editor of the Internet site StocksandNews.com.

Maybe not. But the overall lesson about one-star funds is: Don’t just assume they’re hopeless. For bargain hunters, there may be diamonds in that bin.

To make the best choices, investors need to do that subjective evaluation for themselves, or else have an advisor do it. No one-size-fits-all rating system will ever be up to that job.

Chet Currier is a mutual funds columnist for Bloomberg News.