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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.

Thornburg Developing World THDAX
Another Bronze-rated fund, Thornburg Developing World celebrates its third birthday in mid-December 2012. Like the Matthews fund, it has performed well: Its 9.64% annualized lifetime return through Nov. 23, 2012, lands in the diversified emerging-markets category's best decile. It has done so by adeptly navigating the marked volatility in emerging markets these past three years, performing strongly in both rallies and downturns thanks to a strategy that has both bold and mild characteristics. For example, manager Lewis Kaufman invests across the market-cap spectrum, whereas many in the category stick to larger-cap companies. He also divides the portfolio among value and growth names. Nonetheless, investors should adjust their expectations; it's unlikely the fund will continue to perform as well in sharp rallies because Kaufman maintains a quality bias across the board. If the fund grows quite large--and at just $110 million in assets, it has a long way to go--it could become more difficult for Kaufman to buy smaller-cap firms and maintain a compact portfolio of 40 to 50 emerging-markets names.

Keeley Small Cap Dividend Value KSDVX
At the beginning of December 2012, this small-blend fund will be three years old. Since its inception, it has gained an average annualized 15.47%, landing near its category's best decile. Along with the fund's dividend focus has come comparatively large weightings in the REIT and utilities sectors, and these two areas have been particularly strong--and could carry some price risk at current levels. Keeley specializes in corporate restructurings, but this fund's lead manager was hired in 2009 to broaden the company's lineup with a more diversified strategy. However, like other, older Keeley funds, the portfolio has more in industrials than its peers. Strong stock-picking in that area has been key to the fund's outperformance overall, but investors would be wise to remember that Keeley's other industrial-heavy funds suffered for that leaning in 2008, before this fund was launched. Morningstar doesn't cover this Keeley offering, but rates both Keeley Small Cap Value
KSCVX and Keeley Small-Mid Cap Value KSMVX at Neutral, in part because of a management transition that this fund does not have to contend with.

Causeway International Opportunities CIOVX
Causeway International Opportunities is a fund of two funds. One is the excellent, Gold-rated Causeway International Value CIVVX, which boasts a stable management team, disciplined and bottom-up investment strategy, and superb long-term performance record. To add some emerging-markets exposure--which has become the norm in foreign-stock investing--this fund pairs International Value with Causeway Emerging Markets CEMVX, a quantitatively run portfolio that has behaved similarly to its older sibling. That is, the fund has a good record of returns (excepting a weak 2008), but above-average to high Morningstar risk scores. International Opportunities' allocation to emerging markets can fluctuate, but has so far hovered in the midteens over its lifetime--in line with its MSCI All Country World Index (ex-US). Since its inception through Nov. 23, 2012, the fund has returned 6.38% annually on average, just 6 basis points ahead of International Value. Both records, however, land in the compact foreign large-value category's best decile.

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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