The Stories Behind the International-Fund Rankings

Morningstar does its best to ease the task of choosing mutual funds. That's the reason we installed our category system, which enables you to evaluate funds against rivals having similar types of portfolios and investment strategies.

The categories have changed some over the years. The most important change occurred years ago, when we moved from a system based on the fund's supposed "objective"--growth, growth and income, and the like--to a style-box-based format that classifies funds on what they're actually doing. In the process, the number of groups grew as we added more-specific categories. Since then, we've added some categories and eliminated a few to take into account the changing landscape of the mutual fund universe.

Nearly all funds fit neatly into one of these groups. For one reason or another, though, the existing categories don't provide an ideal home for a challenging few. We don't want to create a new category for every narrow niche, for some groups would have just a handful of inhabitants--but we recognize that, as a result, some funds' classification isn't perfect. So, it pays to take the category rankings of certain funds with a grain of salt--and to understand the nuances that can be obscured if an investor focuses just on where a fund lands on one or two category performance charts. Morningstar's associate director of fund analysis Scott Berry recently discussed how some bond-fund rankings are currently being distorted by the extreme returns of a few. Next week, fund analyst David Kathman will address another angle--how it's useful to delve deeper when looking at funds that change style boxes on the domestic side or whose portfolios lie close to a style-box border. Here's another twist: how the smaller number of categories on the international side means that in certain cases, rankings might not be the clear indicators that they may seem.

Watching over a Wide World
For funds that devote their entire (or nearly their entire) portfolio to foreign stocks, we have created several different categories based on their holdings and investment style: foreign large-value, foreign large-growth, and so on. Not so for the world-stock category. As yet, there aren't enough small- and midcap world-stock funds to merit creating separate categories for them.

As a result, funds with a small-cap or small-to-midcap orientation land in the world-stock category along with the more numerous funds whose portfolios are dominated by big companies. It pays to keep that in mind when you look at category rankings for this group.

For example,  Evergreen Global Opportunities (EKGAX) and  DWS Global Opportunities (KGDAX), which focus on small and midsize firms, have outstanding five-year rankings in the world-stock category. The Evergreen fund, in fact, is the top performer in the entire group, with a 24.1% annualized return over the five-year period through May 1. No doubt, excellent stock selection contributed to the performance of these funds. But it's important to recognize that for most of that period, until 2007 in fact, smaller stocks were posting gains far surpassing those of bigger stocks. Many of the funds at the top of the world-stock group's five-year chart are small-to-midcap funds.

Where would the Evergreen and DWS funds rank in a category that featured hundreds of different funds that owned small and midcap stocks, instead of a dozen or so with five-year records? How will they perform when smaller stocks aren't taking the lead? Maybe they'd still have the same exalted ranking. Maybe not. The point is that understanding the background behind those strong rankings allows you to make a more informed decision on such funds.

Currency Effects Can Cause Confusion
There's a similar situation with funds that hedge their currency exposure. With most foreign currencies appreciating substantially versus the U.S. dollar in recent years, international funds that retain full exposure to those foreign currencies (that is, the vast majority) have had an advantage over rivals that hedge that exposure back into the dollar. As discussed in a previous column, that issue affected only a tiny number of stock funds. 

The effects are complicated by the fact that stock performance, which can vary wildly from company to company, exerts an influence on returns along with currency gains or the lack thereof. On the bond side, however, the currency effect is more direct, because the performance of individual bonds--high-quality bonds, at least--doesn't vary nearly as much as stocks do.

That's important to keep in mind when evaluating funds that invest purely in foreign bonds that are denominated in foreign currencies. Such funds are located in the world-bond category, where they are compared against funds that have amassed fewer currency gains, because the latter also own a large chunk of U.S. securities issued in dollars.  T. Rowe Price International Bond (RPIBX) is one example;  PIMCO Foreign Bond (Unhedged)  is another. Both funds have had stellar rankings in recent years--except, naturally enough, in 2005, when the dollar strengthened and both funds landed in the category's bottom quartile.

As the parenthetical part of the PIMCO fund's name indicates, there's a final twist here. PIMCO also offers a version of its all-foreign bond fund that hedges into the dollar, erasing the currency advantage it would otherwise have enjoyed. Of course, the opposite is also true. Knowing that background, it's no surprise that even though  PIMCO Foreign Bond (USD-Hedged) (PFORX) is run by the esteemed PIMCO bond house, that fund has had lousy rankings for years--except in 2005, when it nearly topped the category.

As you can see, it pays to do a little investigation instead of simply taking these funds' ranking as a sign of their value.

Conclusion
Similar examples can be found in other categories. But the point is clear. While comparisons of funds within categories can be immensely helpful, taking a moment to figure out why the numbers look as they do will make you a better-informed investor and put you in a stronger position to pick the funds that are right for you.