Five-Star Funds to Avoid

I've written in the past about how the Morningstar Rating for funds is calculated and how early tests indicate it has some value in predicting future performance. However, I'm always careful to point out that it's simply a quantitative measure of risk-adjusted performance and therefore does not serve as a substitute for fundamental research. As with any measurement of risk-adjusted performance, including the Sharpe ratio and alpha, there are cases where the fund isn't as good as the performance measure would lead you to believe.

To illustrate those limitations, let's look at some 5-star funds that really aren't as attractive as they seem at first. The biggest limitation of the star rating is that it doesn't incorporate changes to a fund's fundamentals, such as a change in managers or strategies. Even when it comes to reflecting performance, the star rating can miss a thing or two. The star rating rolls up three-, five-, and 10-year returns, but that means that a nine-year-old fund's record from years six through nine won't be reflected in its star rating. In addition, if a fund invests in a super-hot asset class, big returns can mask risks enough so that high-cost, high-risk funds can still win 5 stars. That doesn't happen often, though. Only 58 of the 448 5-star funds (using distinct portfolios only) have expense ratios that are above their category averages.

Here are some examples of funds whose star ratings are a lot better than they are.

 Jacob Internet (JAMFX)
This fund is a classic example of the quirkiness caused by the time periods that factor into the star rating. Investors who bought at inception are still about 70% in the hole, yet this fund still has 5 stars because its horrific bear-market losses are starting to roll off the five-year record.  The fund's 79% loss in 2000 isn't there, and its 56% loss in 2001 is starting to fade.

Needless to say, this is a bad investment and it's one of our two 5-star Analyst Pans. It has high expenses of 2.64%, poor long-term returns, and an unimpressive manager. I was shocked to see a major business magazine include this fund on its list of the best ways to bet on the second wave of Internet stocks.

Rydex Midcap Advantage (RYMDX)
This fund aims to deliver 150% of the beta of the S&P 400. Because mid-caps have been a sweet spot for the market of late, the fund has nifty returns that earn it 5 stars. But this is probably the worst time to buy the fund. The stocks it favors have had a nice run, so that means its risk has gone up. History shows that even a middling market can be murder on a leveraged fund. See  Rydex Nova's (RYNVX) returns for proof.

Eaton Vance Asian Small Companies 
Here's another fund that invests in a super-hot asset class, but its huge expense ratio figures to be a big liability as returns revert to the mean. This small-cap fund also benefits from being an outlier in its category. (There aren't nearly enough Asian small-cap funds to create a category, so this fund is bunched in with other Pacific/Asia Ex-Japan funds that invest primarily in large caps.) Also worth noting is that manager Cho Yu Kooi can only take credit for the last two years of performance.

 Fidelity Export & Multinational 
This isn't a bad fund, but there's nothing very compelling here. Tim Cohen, who had done a great job here, was moved up to run the larger  Fidelity Growth & Income (FGRIX) late last year. Victor Thay was promoted to run this fund. Thay produced mixed results at  Fidelity Convertible (FCVSX) and before that had some short stints at sector funds. So, the fund has gone from a good proven manager to one who's a relative unknown.

 Transamerica Premier Growth Opportunities 
At least Fidelity Export can make the claim that the analysts who contributed to its past success are still there. This fund lost its entire team about a year ago when they left to run money for Delaware Funds. We used to be big fans of the fund, but it's disappointing that Transamerica couldn't hold on to such a talented group.