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By Christine Benz and Shannon Zimmerman | 02-07-2013 12:00 PM

These Funds Are Hidden Gems

These three highly rated, undiscovered funds--two small-cap and one large--are some of Morningstar's favorites.

Christine Benz: Hi, I'm Christine Benz for Not every worthwhile mutual fund has billions of dollars in assets. Joining me to discuss some of Morningstar's favorite funds that are relatively undiscovered is Shannon Zimmerman. He is associate director of fund analysis with Morningstar.

Shannon, thank you so much for being here.

Shannon Zimmerman: Good to be with you, Christine.

Benz: Shannon, let's start by discussing the premise here. Why do you even want to take a look at funds that have relatively smaller asset bases? What's the advantage of doing that?

Zimmerman: Well, so, particularly among small-cap funds, the managers are able to be more nimble in terms of entering and exiting positions. When you think of a small-cap manager trying to build a position in a small-cap company, what's going to happen, if they have a ton of assets, as they are moving into a name, is they're going to move a stock against the fund. They are going to raise prices as they build that position with a lot of money, and as they exit the position, they are going to push the price down because they are withdrawing a lot of money. A small-cap manager with a reasonably sized asset base is able to enter and exit a position, largely at will, without fear of moving the stock price against the fund.

Benz: So, the big advantage is for smaller funds, or funds that invest in less liquid assets, where that's potentially an issue?

Zimmerman: Exactly. Yeah. That's what we are talking about when we use the term asset bloat, one of my favorite fund analysis terms, that's what we mean, when the fund gets too big for moving imminently in and out the kinds of names that it likes for the very reasons that you cite.

Benz: So, let's talk about how the analyst team approaches ratings for these funds that you cover. You have a medal system that you look at. Let's talk about what it takes to garner one of those high Analyst Ratings, either Gold, Silver, or Bronze?

Zimmerman: Sure. We have five ratings; there is Gold, Silver, Bronze, Neutral, and Negative. And to garner a medal is a big thing, even if it is a Bronze medal. That's an endorsing notice on the part of the analyst because that expresses the analyst's belief that over the course of the next market cycle of at least five years, the analyst believes that that fund--Bronze, Silver, or Gold--will be able to beat the typical fund in its category. So, that's a pretty high level of conviction.

From there we look at five analytical pillars. There is People, Process, Parent, Price, and Performance, and we rate each of those independently, though when you get right down to it, of course, there is cross-pollination across those pillars because one informs the other. But we rate each of those as discrete areas, and then those roll up to an overall Analyst Rating. So the ones that we award medals to are the ones that we have the highest conviction in--Bronze, Silver, or Gold. The funds that we are going to talk about today have all garnered nice Analyst Ratings--Silver in two cases, Bronze in one, and not a lot of assets, which is somewhat surprising.

Benz: In contrast with the Morningstar Rating for funds, which is backward-looking and looking at the risk/reward profile, you are really trying to be forward-looking here?

Zimmerman: That's right. What we like to say is that the Analyst Rating is an aptitude test: What is the fund capable of? Whereas the star rating is achievement test: What has the fund done?

Benz: Let's get right on into some of these hidden-gem funds. One of the first ones is a small-cap growth fund. It's Conestoga Small Cap. Let's talk about why the team likes that fund?

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