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It's the Witching Hour for Some Funds

Turning three can be a make-or-break moment.

Bridget B. Hughes, CFA, 11/27/2012

Especially for a newer fund, no one milestone seems as important as its three-year anniversary. It's the earliest point at which a fund can earn a Morningstar Analyst Rating, but it means much more than that. Many institutional and individual investors require at least a three-year track record before even looking at a fund manager or strategy. So, funds' three-year total returns, rankings, and star ratings can mean the difference between economic viability and futility. It's no wonder then that many fund companies emphasize portfolio managers' three-year records in their compensation plans.

The Three-Year Period
For investors evaluating a fund, the three-year return figure is hardly the be-all and end-all. But it's not insignificant, either. Three years is a reasonable amount of time for a portfolio manager to begin demonstrating investment acumen or lack thereof. A three-year record also can help investors set rational expectations for a fund and assign it an appropriate portfolio role.

That said, you have to take three-year records with many grains of salt and ask many questions. For example, did the fund achieve its results with a smaller asset base that allowed it to invest in less-liquid securities that it may not be able to buy should its three-year number attract throngs of investors? Has the sponsoring fund company capped the fund's expense ratio and, if so, how long will that cap or management-fee waiver be in place?

Most importantly, is three years long enough? Asset-management firm GMO estimates that the market passes through its fair value every seven years. If that's true, a three-year period would represent less than half of a market cycle. Many funds aim to outperform their benchmarks only over a full market cycle, which may be shorter or longer than GMO's definition, and it makes sense to evaluate them over such a period.

That's why it's important to put a fund's three-year returns and rankings in context. What kind of market climate has the fund seen? Perhaps the easiest three-year period to evaluate is one that has been marked by a single trend--a thriving bull market or a crushing bear market. The mid- to late-1990s is one such example of a strong up-market, when the S&P 500 Index notched gains in excess of 20% in each calendar year between 1995 and 1999. The trend reversed, and between late March 2000 and early March 2003, the S&P 500 Index, along with other major small-cap and global indexes, moved sharply downward, owing largely to plummeting tech and telecom stocks.

The Past Three Years
The most recent three-year period has given investors a lot to think about. Between Nov. 1, 2009, and Oct. 31, 2012, the S&P 500 Index has gained an average annualized 13.21%. The Russell 2000 Index is up 14.82%. The MSCI Emerging Markets Index has gained 5.38% while the MSCI EAFE Index has gained 2.83%. The markets have trended up, albeit with a lot of volatility, including 2011's third quarter and the spring of 2012. At the same time, there have been times when markets have responded more to global macroeconomic trends and headlines during the past three years. At other times, however, it's clear that either individual-company or industry news has moved stocks.

Examining how young funds have handled those ups and downs can give investors clues as to how portfolio managers deal with a variety of investing climates. Below we take a look at a few funds that are about to turn three. Morningstar analysts cover the first couple, but not the second two.

Matthews China Dividend Investor MCDFX
This China-focused fund turns three at the end of November 2012, and despite investors' recent focus on dividends and yield, it has so far only amassed $43 million in assets. But it's an appealing option. First, Matthews has a lot of expertise in Asian equities and it has long homed in on income-generating vehicles, including convertibles. Here, manager Jesper Madsen likes dividend-paying stocks less for their yield than for the discipline enforced on company managers who commit to paying shareholders regular dividends. The dividend orientation, as well as Madsen's quality and valuation emphases, also helps provide some ballast in what otherwise can be a highly volatile niche: the single-emerging-market mutual fund. From its inception through Nov. 23, 2012, the fund's 9.07% annualized gain sits atop the small China Region category. Although this fund won't reach the asset levels of core-oriented offerings, investors may take further notice, and they wouldn't be wrong to do so. Morningstar gives this fund a Bronze rating.

Bridget B. Hughes, CFA, is an associate director of fund analysis with Morningstar and is also happy to chat with you.

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