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Our Mostly Patient Approach to Analyst Ratings

See how the analyst ratings and star ratings for funds change over time.

Russel Kinnel, 04/01/2013

It has been 13 years since we introduced Fund Analyst Picks, 10 years since we introduced more rigor, including a vetting committee, and just more than one year since we transitioned to the Morningstar Analyst Rating. That gives us a broad swath of time to look at how we rate funds.

In order to illustrate the process, I chose a handful of funds that have been picks or Gold-rated over the years and examined the ratings, performance, and Morningstar Ratings for funds, or "star ratings," over that same time. As you'll see, the picks and Analyst Ratings change far less often than the star ratings.

The star rating is a quantitative measure of a fund's load-adjusted and risk-adjusted performance relative to category peers over the trailing three-, five-, and 10-year periods. In contrast, the Morningstar Analyst Rating is a qualitative fundamental-driven look at a fund's long-term prospects. The star rating is updated monthly, while the Analyst Rating is subject to revision at any time by our analysts and ratings committee. For example, we recently lowered T. Rowe Price Health Sciences PRHSX to Neutral from Gold because the manager left and took two analysts with him. 

While we keep a close eye on funds, we are also patient. Thus, the Analyst Rating and the picks before it tend not to change nearly as often as the star rating. The Analyst Rating reflects things not taken into account by the star rating, such as manager changes, changes in expense ratios, the quality of the fund company, and returns outside of those three-, five-, and 10-year periods. We generally focus on the manager's track record over the entire time he or she was at the fund as well as at other funds or separately managed accounts.

Thus, while most of our Gold-rated funds are 4 or 5 stars, there are some with lower star ratings.

Click on this link to see the graphs for each of the following funds. These exhibits chart the changes in analyst rating and star rating against performance.

Harbor Bond HABDX
Sometimes it is that simple. We made Harbor Bond an Analyst Pick in 1999 and have given it our top rating ever since. It's the most accessible, cheapest retail version of PIMCO Total Return PTTRX, and we've long been fans. By 1999 Bill Gross had already won our Manager of the Year award, and most other taxable-bond funds neither could match PIMCO for resources nor Bill Gross for skill.

Even though the rating seems like a no-brainer with hindsight, it was controversial just a year ago. A bad call led to dismal relative performance in 2011, and many reporters and investors alike said PIMCO Total Return was too big. The star rating dropped to 4, and it only recently returned to 5. We believed that the bad call was the problem, not asset size, and we've seen the fund recover from other bad calls, so we stuck with it. Even someone as good as Bill Gross is going to make errors from time to time. When we evaluate managers, we look to see if their mistakes are within the realm of reasonable expectations and whether they indicate something important has broken down. This fund passed the test, and we kept it a Gold fund. From 1999 the fund has beaten its average category peer by 1.3% annualized.

Templeton Developing Markets TEDMX
Having shared an early success, now I'll share an early dud. At one time, Mark Mobius was the Bill Gross of emerging markets. In fact, he was a bigger star in the early 1990s. His fund was a pick in 1999 and was thought to be not only the biggest but also the best. Templeton has a well-deserved reputation for savvy value investing. However, we noticed the fund was losing its edge as better competitors entered the arena, and the fund's performance was flagging. In March 2002, former Morningstar analyst Emily Hall wrote: "The fund tends to suffer when emerging markets shine, but it hasn't been a bad bet over the long haul. Still, its strong long-term record has more to do with the distinct lack of competition in this asset class than with impressive results. Investors can do better."

In addition, at that time we were becoming more rigorous in our vetting process, and this fund's expense ratio was way too steep despite the strong long-term results. Thus, we kicked it off the picks list. Interestingly, we were in sync with the star rating on this one, as it had fallen to 2 stars, though it later rebounded to 4.

Since then, our opinion and the fund's performance have continued on a downward slope. We rate it Negative because of problems with process and poor performance. The fund's 10-year return is worse than three fourths of its peers. While we were wrong in our initial enthusiasm for the fund, I'm pleased that we dialed up the scrutiny and guided investors away from it.

While we try to be early and go against the grain, here's one where we went with the flow but things still turned out well. We made Bob Rodriguez's FPA Capital an Analyst Pick in July 2002, right near the bottom of the bear market. Some managers think defense first. Bob Rodriguez thinks defense first, second, and third. Thus, the fund held up much better than most funds in 2001 and boasted one of the best 10-year records when we made it a pick. However, it was only 3 stars at the time.

Rodriguez picked up some bargains in the sell-off, but the fund still lagged in 2003 and 2004 as you'd expect for a fund focused on capital preservation. However, we stuck with it because it was behaving just as we expected. In 2007, it briefly fell to 2 stars. Yet once again, when the bear market struck, FPA Capital held up much better than its peers. It even had a brilliant 2009 as Rodriguez and comanagers Dennis Bryan and Rikard Ekstrand scooped up bargains in the meltdown that powered further gains.

We dropped the fund from our picks list in 2010 when Rodriguez departed for a year with the promise to come back to FPA in a reduced role. Bryan and Ekstrand are skilled managers running an excellent strategy, but we felt the record was largely Rodriguez's, and that was enough to take the fund down a notch. Today we rate it Silver.

Primecap Odyssey Aggressive Growth POAGX
This one was right in our wheelhouse. We knew Primecap well, and we had watched Vanguard Capital Opportunity VHCOX start out as an aggressive small/mid-growth fund and produce outstanding results even as asset growth pushed it to large-cap land. The firm has a great investing culture, and its funds have low costs. The fund was launched in November 2004, and we made it a pick in March 2006 before it even had a star rating. When all the fundamentals come together like that, the results can be great, and they have been so far for this fund.

Although the fund's first star rating was just 3 stars and it briefly dipped to 2, we stuck with it. Now the star rating is 5, and the Analyst Rating is Gold.

Calamos Convertible CCVIX
Calamos Convertible has had less drama than most of the above funds. We liked Calamos' expertise in the convertibles niche. It had a clear competitive advantage, as few firms can match its depth in the field. We also liked its skill at diving deep into balance sheets to avoid the really risky stuff in a category where credit quality is often rather low. The fund was a pick from January 2001 through November 2011. Over that time, it modestly outperformed by holding up well in the credit meltdown of 2007 and 2008 as it lost less than most of its peers.

In 2011, we decided it was solid but not quite worthy of a Gold rating because of a mix of fees, performance, and stewardship. We awarded it a Silver. Then, we took it down a notch to Bronze following Nick Calamos' departure in 2012. We felt the team was still deep, but Calamos' departure was a loss.

Our opinions evolve as the fundamentals of a fund evolve, such as management, expenses, or long-term risk-adjusted performance. More gradations of ratings allow us to make our conviction clear--for instance, a shift to Silver from Gold means that we still hold a fund in high regard even if it isn't quite good enough to win our top rating.

The five pillars of our ratings--People, Process, Parent, Performance, and Price--focus on the drivers of competitive advantages such as managers, strategy, analysts, fees, and the firms backing the portfolio management teams. These things tend to be more stable than performance, so, generally speaking, most of our Analyst Ratings won't change much over time.  

Russel Kinnel is Morningstar's director of mutual fund research. He is also the editor of Morningstar FundInvestor, a monthly newsletter dedicated to helping investors pick great mutual funds, build winning portfolios, and monitor their funds for greater gains. (Click here for a free issue). Mr. Kinnel would like to hear from readers, but no financial-planning questions, please. Follow Russel on Twitter: @russkinnel.

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