The Short Answer: Find Hidden Fund Gems.

Byline: David Kathman, CFA

Dec. 12--Back in October, we took a look at some of the pluses and minuses of the Morningstar Rating for funds, better known as the star rating. That rating is well known as a quick way to evaluate a fund's risk-adjusted performance relative to its peers, but it doesn't always tell the whole story. Some funds with high star ratings are less attractive than they might appear at first glance, usually because the manager responsible for good past performance has left or because the fund occupies a hot niche that has temporarily inflated performance.

Just as a high star rating is no guarantee of a good fund, the opposite is also true. A low star rating does not necessarily mean a fund is bad; in fact, there are plenty of very good funds out there that sport 1 or 2 stars, including quite a few Fund Analyst Picks. Someone who automatically excluded funds for having a low star rating would be missing out on some real winners. Looking beyond the usual 4- and 5-star suspects can reveal some excellent funds that don't deserve to be overlooked.

--Positive Manager Changes

In our earlier column, we noted that a high star rating and good long-term track record don't mean much if the manager responsible for that record has recently left. The opposite is also true: A low star rating and poor long-term record don't matter if the managers behind that record are gone. Such a fund can actually be quite attractive if the new manager has a strong record elsewhere, or has put together good results since taking over.

For example, consider FPA Paramount. This fund has a Morningstar rating of 2 stars, mainly because of a terrible 10-year record that ranks in the bottom 5 percent of mid-cap blend funds. However, since current managers Erik Ende and Steven Geist took over the fund in March 2000, it has looked much better, finishing in the category's top quartile four times and beating its peers over the trailing five years. The same managers have compiled an excellent record at the similar FPA Perennial since 1995. For all these reasons, plus a big tax-loss carryforward left over from before Ende and Geist took over, FPA Paramount is an Analyst Pick in the mid-cap blend category despite its 2-star rating.

USAA Aggressive Growth is a similar example. Like FPA Paramount, it's an Analyst Pick (in the large-growth category) even though it has a rating of 2 stars and poor 10-year relative returns. In this case, the manager is Tom Marsico, who began subadvising the fund in mid-2002 after dismal results from previous management. Marsico has built one of the best long-term records of any large-growth manager; he managed Janus Twenty from 1988 to 1997, and since starting his own shop he has guided Marsico Growth and Marsico Focus to great returns and 5-star ratings. Since he took over, this fund has consistently beaten its category, and we just recently made it a large-growth Analyst Pick--replacing Marsico Focus, which has slightly higher expenses.

--Steady Funds in Hot Categories

When a category has been hot for several years, disconnects can arise between the quality of funds in that category and their star ratings. In our earlier column, we showed how an ultra-risky fund such as Jacob Internet can be an Analyst Pan despite a 5-star rating, if flashy short-term results don't look sustainable. The flip side is when an attractive, relatively stable fund with good long-term prospects underperforms its flashier peers for a few years, resulting in a low star rating.

One good example is American Funds New World, which is an Analyst Pick in the diversified emerging-markets category despite its current 1-star rating. This fund combines direct emerging-markets exposure with indirect exposure through U.S., European, and Japanese stocks that get a lot of their earnings from emerging markets. These developed-market stocks have kept the fund's volatility low relative to its category peers, and experienced managers and low expenses make it even more attractive for the long term. However, the riskiest emerging-markets stocks have been on fire the past five years, and this fund has not been able to keep up with pure-play emerging-market peers during that time, even on a risk-adjusted basis. It doesn't help that this fund doesn't yet have a 10-year record, so its star rating is based entirely on its three- and five-year records, and its top-decile returns in 2000 are not included.

A similar story surrounds American Century Global Gold, a 2-star Analyst Pick in the precious metals category. The fund focuses on stocks of large, diversified gold producers, mostly avoiding smaller, less-diversified companies that are more directly sensitive to gold prices. That has not been a particularly good place to be as gold prices have gone up in recent years, so the fund has trailed its peers. However, it's a good, solid way to get gold exposure over the long run, and an experienced manager (in place since 1992) and low expenses are icing on the cake.

--When Returns Aren't the Focus

Finally, the star rating can be somewhat misleading in certain categories where stability and low costs tend to be just as important as returns. For example, both of our Analyst Picks in the new bank loan category currently feature low star ratings: Eaton Vance Floating Rate has one star, while Fidelity Floating Rate High Income has two. Neither fund has particularly high risk-adjusted returns relative to the rest of the category, but we like them because of their low volatility and stable returns, as well as experienced managers and the Fidelity fund's low expenses.

In the new target-date 2015-2029 category, we have six Analyst Picks, including three T. Rowe Price funds and three Vanguard funds, with target dates of 2015, 2020, and 2025. Because these are such new funds, only three of them currently have star ratings; one of these, Vanguard Target Retirement 2015, gets just 2 stars, mainly because its 50 percent stock weighting has been lower than the 62 percent average for the category. Another of these Picks, Vanguard Target Retirement 2025, gets 3 stars. However, trailing returns are much less important for such funds than their asset allocation schemes, which will change over time by the nature of the funds, and their costs. The Vanguard funds are among the cheapest in the category, which is a big reason why they're Analyst Picks.

The examples we have looked at have all been Analyst Picks, and our lists of picks in each category are a great way to identify the best funds in a category, regardless of star ratings. However, there are plenty of other good funds that are better than their star ratings might lead you to believe at first glance. You'll need to do some reasearch to find them, but knowing what to look for--recent manager changes, hot categories -- can make that task easier.

David Kathman, CFA does not own shares in any of the securities mentioned above.

David Kathman, CFA may be reached at david_kathman@morningstar.com.

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Copyright (c) 2006, Morningstar Column

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