How to Avoid 5-Star Duds

The Morningstar Rating for funds, better known as the star rating, has always been one of our best-known and most popular features. However, it's important to recognize what the star rating can and can't do. We designed it as a concise way to measure a fund's risk-adjusted past returns against its peers, and on that count it does a very good job, especially since we improved the methodology a few years ago. But past performance is no guarantee of future results, and the star rating is not meant as a way to predict which funds will do well going forward.

While it's true that highly rated funds tend to do somewhat better going forward than low-rated funds, as we found in a preliminary study, we always advise investors to go beyond the star rating. Screening for funds with 4 or 5 stars is a reasonable way to start winnowing down the fund universe to a more manageable group, but it also pays to look beyond the star rating and do more fundamental research. Here are a few ways to watch for funds whose star rating might not tell the whole story and to find hidden gems that might be overlooked by star-struck investors.

Beware of Manager Changes
One important limitation of the star rating is that it doesn't take into account manager changes or other significant changes in how the fund is run. If a fund has been in existence for 10 years, its star rating will incorporate that whole time frame, even if most of that performance was under a manager who's no longer around. That's why it's always a good idea to check highly rated funds to see how long the current management team has been in place, because a rookie manager will tend to make such funds less attractive than they might appear at first glance.

For example,  Sentinel Small Company (SAGWX) was a 5-star Analyst Pick in September 2004 when longtime star manager Scott Brayman left to form his own firm. Brayman was replaced by Chuck Schwartz, who had been an analyst on the fund but had never run a mutual fund before, and we dropped the fund from our pick list. Although Schwartz has done a respectable job in his first two years, the fund is not as attractive as it was under Brayman despite still being rated 4 stars. On the other hand, Brayman's new fund,  Champlain Small Company (CIPSX), is now an Analyst Pick in the small-growth category, largely because of Brayman's stellar track record at Sentinel. It's too young to earn a star rating, but we consider it one of the best funds in its group.

A similar example is  Columbia Small Cap Growth I (CMSCX), which we don't recommend to investors even though it sports a 4-star rating. The fund lost longtime manager Richard Johnson in June 2004, and a fair amount of manager turmoil has ensued since then, with former analyst Ken Korngiebel working with a changing cast of comanagers. The fund's track record is still good enough that it's rated 4 stars, but all the management turmoil has been such a negative that we list it as a small-growth Analyst Pan, or one of the stocks we suggest investors should avoid.

Fidelity has a number of 5-star funds that we don't think much of, mainly because of management turnover. Such turnover has been a particular issue at Fidelity, where managers, especially in sector and specialty funds, often seem to go through a revolving door. For example,  Fidelity Export & Multinational  sports an apparently impressive 5-star rating, but the manager behind most of that rating, Tim Cohen, left in late 2005 to run the much larger  Fidelity Growth & Income (FGRIX). His replacement, Victor Thay, is more of a question mark and could end up also being moved to another fund if he does well here. Other Fidelity funds with 5-star ratings but relatively untested managers include  Small Cap Independence (FDSCX) and  Large Cap Value (FSLVX), neither of which we're very excited about.

Of course, a manager change isn't always a bad thing, and there are plenty of highly rated funds that we've continued to like even after a longtime skipper left. While a recent manager change on a highly rated fund should be a red flag, it's always a good idea to do some research before jumping to conclusions.

Beware of Funds in Hot Areas
Another situation where a high star rating doesn't necessarily tell the whole story involves funds specializing in areas of the market that have been particularly hot. This is especially true when a fund specializes in a market niche that doesn't have its own category but is part of a much broader group; such funds can rank very high or very low within their categories depending on the performance of their market niche over a relatively short period of time.

For example, the past few years have been unusually favorable to such risky investments as micro-cap stocks, emerging-markets stocks, and high-yield bonds, giving a big short-term boost to funds specializing in those things. It's easy to get seduced by such funds' apparently strong results and high star ratings, but those can be very misleading. That's especially true when a fund has been around for more than five years but fewer than 10, because the star rating is based only on a fund's three-, five-, and 10-year results.

The poster child for this type of fund is  Jacob Internet (JAMFX). At first glance it looks pretty good, with a 5-star rating and three- and five-year returns near the top of the technology category. However, that five-year record does not include the fund's horrific 79% loss in 2000, one of the worst in the category, or most of its 56% loss in 2001. Even with the recent recovery, somebody who bought the fund at its December 1999 inception would still be down by about 75%; those earlier losses aren't taken into account in the fund's star rating, which only incorporates its three- and five-year records. The extremely speculative stocks preferred by this fund have been temporarily in favor since early 2003, but they're bound to hit the skids sooner or later. Add an excessively high expense ratio, and Jacob Internet is a 5-star Analyst Pan.

Another 5-star fund on our Analyst Pan list is  U.S. Global Investors Eastern Europe . As its name implies, this fund specializes in stocks from Russia, Poland, Hungary, and other Eastern European countries. Those extremely volatile markets have been on fire in recent years, helping the fund to a 5-star rating and one of the best five-year records in the often-stodgy Europe Stock category. But, as with Jacob Internet, the fund has enjoyed a lot of positive conditions during that period, and its lack of a 10-year record means that its terrible performance in 1998 and 2000 (when it lost more than 20% and ranked in the category's bottom 10% each year) doesn't figure into its star rating. The fund's 10-year anniversary is coming up in March 2007, and it's likely to look less attractive once its 10-year record is thrown into the mix.

Beyond the Star Rating
All this shows that the star rating should be a starting point but not an ending point for your research. Fundamental research can usually help distinguish the real winners from the poseurs, but not everybody has time to read through dozens of Analyst Reports weighing the pros and cons. A quicker way to zero in on the most attractive funds in any given category is Morningstar's lists of Analyst Picks, alluded to above. These are the funds that our analysts like the best and feel most confident recommending to investors, and the list is constantly being updated to account for changing circumstances (such as a new manager).

There's definitely a correlation between Analyst Pick status and the star rating, but it's far from absolute. Of the 175 funds we currently list as picks, 31 have 5 stars, 72 have 4 stars, 41 have  3 stars, eight have 2 stars, two have 1 star, and 21 have no star rating, generally because they've been around fewer than three years. Somebody focused entirely on the star rating would probably miss out on lots of very attractive Analyst Picks whose star ratings don't look great right now. These include such gems as  Clipper (CFIMX) (3 stars), now managed by 2005 Morningstar Domestic-Stock Managers of the Year Chris Davis and Ken Feinberg;  FPA Capital  (2 stars), run by 1994 Manager of the Year Bob Rodriguez;  Oakmark Fund  (OAKMX) (3 stars) and  Oakmark Select (OAKLX) (2 stars), both comanaged by 2001 Domestic-Stock Manager of the Year Bill Nygren; and  Weitz Value (WVALX) (3 stars), run by value-investing legend Wally Weitz.

The upshot of all this is that the star rating is a valuable tool, but one that has to be used effectively. There's no automatic path to riches in the fund world, but you can definitely improve your odds if you know what you're doing and avoid getting star-struck.