How to Be Cheap, Contrarian, and Happy

Morningstar analysts receive a lot of e-mails that give us valuable guidance about what funds we should cover and how we should cover them. Our communication with readers also gives us insight into readers' questions and concerns.

Over the years, many of the questions we have received have converged around similar themes. I'll answer some of the most common questions in this article and also shed light on Morningstar's overall philosophy for making money in mutual funds.

1) Why would you give a good recommendation to a fund that's been a poor performer recently, while panning another fund with very strong returns?
This is the most frequently asked question we receive, bar none. And it's easy to see why. After all, if a fund has delivered good performance in the past, isn't it apt to do so in the future? And aren't stinkers likely to stay stinky?

Not necessarily. True, our research has demonstrated that strong performance over a very long time frame (say, greater than 10 years) tends to be somewhat predictive of future strong performance. But in general, a fund's past history isn't particularly indicative of how it's apt to behave in the future. (It's not for nothing that fund companies have to plaster the disclaimer "past performance is no guarantee of future results" all over their literature.) The key reason is that investment styles tend to swing in and out of the market's favor, and even the best fund managers cool off after posting an extended period of strong returns. Moreover, it stands to reason that after a fund's favored securities and sectors have gone up for a sustained period of time, they're likely to be less attractively valued than they used to be.

For all those reasons, we think it's more valuable to focus on a fund's "fundamentals"--the quality of its management and stewardship, the sensibleness of its strategy, and its costs--than on its past performance. And if you're comfortable with those features, you can use a period of weak returns as a buying opportunity rather than a reason to sell. That's why you'll often see us pounding the table for offerings whose performances are in the dumps, as we have with funds like  Aston/Montag & Caldwell Growth (MCGFX), while telling you to steer clear of potentially overheated funds.

2) This fund has 5 stars, so why don't you like it?
This question is a close cousin of the preceding one, and the answer is quite similar, too. The Morningstar Rating for funds is designed to be a quick summation of how a fund has balanced risk and return in the past (for details, click here), but it doesn't encompass everything worth knowing about an investment. No quantitative measure ever could, and the star rating is a strictly quantitative measure. Because we root our recommendations in forward-looking fundamental analysis, it's highly possible for an analysis to conflict with a star rating. For example, we began sounding the alarm bells over unchecked asset growth at  Calamos Growth (CVGRX) back in 2003, even as the fund boasted a 5-star rating. Conversely, we made  Harbor International Growth (HIIGX) a  Fund Analyst Pick--even though the fund had just 1 star--because we liked its prospects under new manager Jim Gendelman.  

3) Why are you so obsessed with fund expenses? Why should I care about expenses if a manager has delivered the goods?
As noted earlier, a fund's past returns won't tell you much about how good it will be in the future. So, what will? Through all of our research on mutual funds, we've found that a fund's expense ratio is more closely correlated with future returns than any other data point. In fact, my colleague Russ Kinnel recently conducted research that showed that funds with expenses in the highest 40% of their category had an abysmal chance of besting their rivals. Meanwhile, you greatly stack the odds in your favor by homing in on funds in the cheapest 25%. If it seems that we're overlooking a fund's strong points and instead homing in on its costs, that's why. That research is also why we're comfortable recommending a fund like  Vanguard Dividend Growth (VDIGX), which has a so-so track record but very low expenses, over a pricier but strong-performing fund such as Fifth Third Multi Cap Value .

4) Why don't you cover my fund?
We provide analyst coverage on more than 2,000 mutual funds, exchange-traded funds, and closed-end funds. By "coverage," I mean that we write reports detailing a fund's management and strategy and ultimately tell readers whether we think a fund is a good investment or a poor one.

That 2,000 figure might seem like a drop in the bucket, given that there are more than 7,000 distinct funds in existence. But because we cover the biggest, most widely held funds, the 2,000 funds in our universe encompass more than 90% of assets in mutual funds today. Although we can't cover all 7,000, we think we do a pretty good job of covering the funds that matter to our readers.

Arriving at that list is more art than science. I compile it, along with help from our analyst team (in particular, senior analyst Todd Trubey and associate director of fund analysis Scott Berry), by looking at a host of different factors. A fund's asset size, obviously, is one of the key factors we consider, because it's a rough gauge of how many investors might be interested in it. However, we love nothing more than calling our readers' attention to new offerings or smaller funds that merit more notice than they've gotten. Thus, we also take into account a fund's management team, history of stewardship, and strategic attributes when determining what to cover. We also look for unique investment strategies that add something to an investor's tool kit. That's why we were quick to pick up on commodity funds when they began launching 10 years ago, and we've also added to our coverage of bank-loan offerings over the past few years. 

Finally, we also take our readers' interest level into account when compiling our coverage list. If a fund has a high number of "hits" on Morningstar.com, we'll strongly consider bringing it under coverage. Readers can also e-mail us directly about the funds they think we should cover and why.