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What to Make of Analyst Ratings Changes

Christine Benz

Christine Benz: Hi, I'm Christine Benz for

Morningstar's Fund Analyst Ratings aim to give investors a sense of whether a fund is worth owning or not.

Joining me to discuss some funds that have recently changed in the rating scale are Russ Kinnel--he's director of fund research for Morningstar--and Dan Culloton, associate director of fund analysis for Morningstar.

Russ and Dan, thank you for joining me.

Russel Kinnel: Good to be here.

Dan Culloton: Pleasure to be here.

Benz: So let's start by doing a little stage-setting and talk about the key catalysts for ratings changes. What would you be looking at if you were upgrading funds or deciding to downgrade them?

Kinnel: So really it's key changes in the fundamentals. Manager changes, expense ratio changes, strategy shifts, asset bloat--maybe a fund has shed assets and now is more attractive. So really kind of key fundamentals.

Benz: So performance alone wouldn't typically be a reason for an analyst to downgrade a fund?

Kinnel: Typically not, but there is information there. We pay a lot of attention to performance, because that is good information, but generally that's not the only reason.

Benz: You are looking for some fundamental problem.

So, say, I am looking at a rating of a fund that I own, and I see that it has recently gone down. Should that be an impetus for me to consider selling at that point? What should I make of these ratings changes?

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Kinnel: Well, I wouldn't say necessarily you should sell it, particularly given if it only drops to Silver or Bronze, we are still recommending it. But also, we don't know what any individual investor's particular situation is. Obviously, if we rate it negative, then maybe it's more likely you'd consider selling. We don't know anyone's particular situation.

Benz: And if a fund moves from, say, Gold to Silver, that's probably not a reason to panic and think about selling.

Kinnel: Right. We still have a high opinion of it, clearly, if it's Silver.

Benz: OK. Dan I want to start with you, because we want to talk about some funds that have recently changed ratings, or have changed ratings since we initially launched these Analyst Ratings about a year ago.

Let's start with a Vanguard fund. We generally like Vanguard funds, but this one we have recently backed off a very high rating and given it a little bit of a downgrade. Let's talk about the fund and why that ratings change occurred?

Culloton: Vanguard International Explorer is … a typical Vanguard fund that has low expenses, that has experienced management, established strategy, long-term focus strategy, and a pretty competitive long-term record.

But we recently re-evaluated it because most of the money that will be coming into this fund from here on out will be allocated to a relatively new manager that has a more mixed long-term track record at other funds.

Like a lot of Vanguard actively managed funds, International Explorer is multi-managed. It has more than one subadvisor. And it’s long-term is subadvisor Schroder Asset Management, and they’ve done an excellent long-term job. But in 2010, Vanguard added a manager from Wellington, Simon Thomas, who very well may turn out to be a great manager. But right now it's a little bit more uncertain, given his track record and given the change. So we've moved the fund from Silver to Bronze for that reason.

Benz: Russ, another set of international funds that were downgraded over the past few months--Artio's international equity funds. What's going on there? I know there have been some performance issues, but you are not just looking at performance alone there.

Kinnel: Right, we kind of have a negative cycle here, where they are in four years of really bad performance. We do pay some attention to performance, and what that does tell us. And in this case, it's clear that they are macro investors, but their kind of macro isn't really in sync with the current macro environment, which is all about central bank moves, deficit bailouts, that kind of thing, and so things haven't worked there, so that's interesting.

But also we are seeing very big outflows from the funds, and then maybe most important there is some staffing reductions at the firm, and all those are worrisome. So we lowered them from Silver to Bronze.

Benz: Dan, another fund that you want to talk about, it’s a BlackRock fund that you think has a conflict of interest issue potentially, and that is one reason it was flagged for a downgrade. Let's talk about that situation?

Culloton: Well, it's really a conflict issue that morphed into a management change issue--and that's BlackRock Energy and Natural Resources. They had a very experienced manager, Dan Rice, who had run the fund for more than two decades. He stirred a bit of controversy recently, when it became revealed that a private drilling company that his family owned that he founded in 2005 had some dealings with one of the holdings in his funds, Alpha Natural Resources.

Eventually he decided to step down from that fund due to this controversy and will leave BlackRock at the end of the year, and he bequeathed the fund to his assistant managers, who are also very experienced, but it just created a little bit more uncertainty over whether the fund can continue on the track that it had established over the long term. So we downgraded that fund from Bronze to Neutral.

Benz: Russ, you also noted that a Pioneer Fund has had a manager change that has made us less positive on the fund than we once were. Let's talk about that particular fund and what's going on there?

Kinnel: If you think about it, when you change subadvisors, it's really a more a dramatic change, because you're not just changing one manager, you're changing analysts as well--so the whole team. And in this case, Pioneer fired Cullen, which is an experienced value firm that actually had a pretty good record, though had been sluggish off late, and they brought the fund in-house. And so you're moving from managers with better records to less-proven managers. So we took the fund down to Neutral.

Benz: Did the expense ratio go down when they brought the fund in-house? I know that sometimes that cost savings are touted as one of the reasons to do that.

Kinnel: We have not yet seen that, but I wouldn't be surprised if it's little more profitable for them to run in-house.

Benz: So, Dan, not all the ratings have been downgrades. Let's talk about some funds that have recently been upgraded--and one is a suite of Vanguard products, the Vanguard LifeStrategy Funds. What do you think makes them look better now than they did when they were initially rated?

Culloton: We always liked Vanguard LifeStrategy Funds. We came out with a Silver rating on them initially. They are fund-of-funds that heretofore had used a mix of active and passive funds for their underlying holdings.

Last year they changed that, and now they're using all index funds. So it's much simpler, much more transparent portfolio construction, and it also lowered the overall fees, which is also good.

But what was really interesting is that one of the active funds that the LifeStrategy Funds depended on was Vanguard Asset Allocation, which was really sort of an outlier in the Vanguard lineup. It was a strategic allocation fund that tried to tactically pick whether stocks or bonds were going to outperform over the long term, and its track record was pretty mixed. Vanguard decided to merge that fund away into Vanguard Balanced Index, and so naturally it's no longer of use in the LifeStrategy Funds, and it helped give the LifeStrategy Funds a much more predictable asset allocation and a much more transparent structure, and so we like that.

Benz: We think they're good basic building blocks then, as they are currently constructed.

Culloton: Yes. Excellent core holdings, and they get a Gold rating.

Benz: Russ, you also wanted to talk about some Columbia international funds that are recently looking better in the ratings scheme. Which funds are those?

Kinnel: That's right. Columbia Acorn International and Columbia Acorn International Select. They are funds that the managers and analysts kind of have equal duties in that they all have parsed out various regions, and each one takes tremendous responsibility for the stocks they own, and over time we've come to know the strategy better and the analysts better, and have really started to appreciate the results. This is a really nice risk-adjusted performance. They don't have really big bets on any one stock, but over time we've gotten to appreciate how well that works, and performance has continued to hold up well. So we've raised it from Bronze to Silver, because we just feel like it's a really strong offering right now.

Benz: OK, so some positive stories in there, too. Thank you both for sharing your insights on these ratings. Very interesting stuff.

Culloton: Thank you.

Kinnel: You're welcome.

Benz: Thanks for watching. I'm Christian Benz for