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When the Facts Change, So Can Morningstar Analyst Ratings

Here are some examples of Analyst Ratings we've changed due to altered circumstances.

Dan Culloton, 06/21/2012

Morningstar fund analysts try to keep an open mind when reviewing the Analyst Ratings they've assigned so far. Less than a year old, the Analyst Rating is our forwarded-looking, qualitative, bottom-up assessment of a mutual fund's prospects. So far, we've researched the personnel, investment processes, parent companies, price, and performance of nearly 900 funds and awarded them ratings of Gold, Silver, Bronze, Neutral, or Negative. We plan to rate  a total of 1,500 funds, but as my colleague Russel Kinnel noted earlier this week, the ratings are not necessarily permanent. Fund managements, strategies, fees, and risk/reward profiles change, and we'd be fools not to reconsider our recommendations upon learning significant new information. Indeed, there already have been a few upgrades and downgrades as the analysts continue to monitor the funds they've rated since last fall and update them because of both obvious and subtle alterations. Here's a sampling of them.

Upon Further Review
Vanguard International Explorer VINEX is an example of subtraction by addition. It has many of the tools needed for success: low fees, experienced management, an approach focused on higher-quality foreign small-growth stocks, and a competitive long-term record. Morningstar Analyst Karin Anderson and the international ratings committee recently took the rating down a notch from Silver to Bronze, though. The manager who's responsible for much of the fund's since-inception results--Schroder Asset Management's Matthew Dobbs--is no longer solely responsible for its future. Vanguard added Wellington Management's Simon Thomas as a second subadvisor to the fund in 2010. Thomas started out with a small slice of International Explorer but will manage more as new money comes into the fund. He and his team also have a shorter and mixed track record at Hartford International Small Company HNSAX. The Vanguard fund still earns a recommendation, but with less conviction due to the uncertainty of how this subadvisory arrangement will work out.

Conflicting Opinions
Dan Rice is known for looking at energy companies like an operator. It gave him an edge in the equity-energy category and helped him earn a strong long-term record and a Bronze rating for BlackRock Energy & Resources SSGRX. Rice may have been too much of an operator, though, and that eventually complicated his fund management job.

This past week, Rice resigned as manager of the fund he'd managed for State Street and then BlackRock for more than two decades after The Wall Street Journal columnist Jason Zweig called attention to potential conflicts of interest between a drilling firm Rice founded in 2005--Rice Energy--and one of the fund's holdings. Rice Energy, which has been run in recent years by Rice's sons, has had a joint venture with one of Energy & Resources' top-five holdings, Alpha Natural Resources ANR, for about two years. Neither Rice nor BlackRock saw any conflict because Rice recused himself from his family's dealings with Alpha and had no day-to-day responsibilities at Rice Energy. That explanation failed to dispel the controversy, though, so Rice stepped down from the fund, but not his BlackRock institutional accounts. The episode raises questions about the fund's remaining management team, which includes longtime comanager Denis Walsh. It's also a strike against BlackRock's stewardship. The fund's rating is Under Review while analyst Rob Wherry gets answers.

The Unforgiven
"One bad move can turn your whole world upside down/It's such a shame 'cause you've been so good up to now." Singer-songwriter Lyle Lovett's hook came to mind when considering Pioneer Cullen Value CVFCX. Here was a fund with a decent long-term record--which included five top-quartile calendar years out of the last 10--compiled by a subadvisor that had been at the helm since its 2000 inception. Pioneer ditched Cullen Capital Management earlier this year, however, assigning an in-house team following three sub-par calendar years in a row. It's not unusual for good managers to suffer performance droughts of three or more years. Indeed, Morningstar has forgiven funds in the past for similar slumps as long as the personnel and process that produced the better long-term numbers remain intact. Pioneer was less forbearing, though, and sacked Cullen. It's not clear how new managers Ned Shadek and John Peckham will do here, so Morningstar analyst Flynn Murphy and the domestic analyst rating committee dropped the fund's rating to Neutral from Bronze.

I'll Take the Upgrade, Please
Vanguard's LifeStrategy series of funds were always good one-stop options for investors who didn't want to bother with building and rebalancing their own fund portfolios. A change in 2011's fourth quarter improved them by cutting a subpar active fund from its holdings and helped boost their ratings to Gold from Silver.

In late September 2011, Vanguard decided to make the four LifeStrategy funds of funds all-index. The four static asset-allocation funds that had used a mix of passive and active strategies have eliminated their active funds--Vanguard Short-Term Investment Grade VFSTX and Vanguard Asset Allocation--and now rely on the index-based and Gold-rated Vanguard Total Stock Market Index VTSMX, Vanguard Total Bond Market II Index VTBIX, and Vanguard Total International Stock VGTSX funds.

The change simplifies the LifeStrategy funds, lowers their costs, and increases their transparency. It also attunes the funds, which were launched in 1994, with Vanguard's current asset-allocation research and approach, including its all-passive, Gold-rated Target Retirement series. The move, however, also forced the fund family to look hard at Vanguard Asset Allocation, and it didn't like what it saw. Losing the LifeStrategy funds stripped Vanguard Asset Allocation of nearly two thirds of its assets. That fund, which  tried to shift opportunistically among stocks, bonds, and cash, also had a poor record. Vanguard merged it earlier this year with Vanguard Balanced Index VBIAX.

Dan Culloton is an associate director of fund analysis for Morningstar and editor of Morningstar's Vanguard Fund Family Report, a monthly newsletter that offers independent, no-holds-barred guidance on the pros and cons of this dominant fund family. Click here for a free issue of the Vanguard Fund Family Report.

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