These Star-Starved Funds Can Still Shine

The distinction between the Morningstar Rating for funds and  Analyst Picks can be a bit confusing, and the two don't always agree. Here's a quick summary: The star rating is a purely backward-looking, quantitative measure, updated monthly, that's based upon past performance. It is designed to give investors a quick snapshot of how a mutual fund has balanced risk and return in the past and compares a fund against its peers in the same fund category.

Analyst Picks, on the other hand, are forward-looking, qualitative selections based on our fund analysts' opinions. We assign an analyst to each fund category, and he or she is responsible for knowing the funds in that group inside and out and selecting a handful of picks. We have regular reviews in which the analyst defends his or her recommendations to a four-member, senior committee.

Check out this recent article to see what analysts consider when selecting a pick, and click here to learn how to use our picks in conjunction with the star rating. For an interesting analysis of how Analyst Picks have fared compared with the star rating, see this article. (Analyst Picks are a benefit of Premium membership. If you are not a Premium Member, you can still sample our picks by taking a 14-day free trial).

Because Analyst Picks are not based solely on performance, we will occasionally have picks that are only 1- or 2-star funds. Although seemingly contradictory, our analysts sometimes have reasons to stand behind funds with disappointing performance histories. Why? Perhaps there was a manager or strategy change that we think will send the fund in a new direction. Or we may think the fund's strategy is sound and will redeem itself in the long run. Here are a few current Analyst Picks whose star ratings don't tell the full story:

 Bridgeway Small-Cap Growth 
Star rating: 2 Stars
From the  Analyst Report:
Bridgeway Small-Cap Growth hasn't yet delivered on its substantial potential and has looked downright awful lately, but patient shareholders should be rewarded. It lost a stomach-churning 43% from Feb. 12, 2008, to Feb. 12, 2008--5 percentage points more than its typical category rival and 8 more than its benchmark, the Russell 2000 Growth Index. What's worse, the fund has lagged since its October 2003 inception. Despite the fund's struggles, we remain believers. Lead manager John Montgomery has a long record of success as a quant investor. Bridgeway is also committed to keeping its funds competitive through a combination of small, flexible asset bases, modest fees, and low trading costs. Although those traits haven't yet paid off, we like the fund's chances over the very long haul.

 Schneider Value 
Star rating: 1 Star
From the  Analyst Report:
Schneider Value has shown its ugly side, but not all is lost. Manager Arnie Schneider's swing-for-the-fences approach has come up short during the past few years. Mistakes in the financials and mortgage industries, including large stakes in beleaguered Countrywide in 2007 and Fannie Mae (FNM) and Freddie Mac (FRE)--which he continued buying in 2008--hit the fund hard, and the problems kept coming as American International Group (AIG) failed. The severity of the fund's plummet shines a harsh light on the risk embedded in Schneider's uncommon strategy: he delves into some of the cheapest and weakest companies in the most distressed industries if he thinks a stock's turnaround potential will lead to outsized returns. The upside to such a strategy can be rewarding, but investors here must have the temperament, means, and time horizon necessary to endure periods of weakness. We're sticking by this fund, but it is definitely not a core holding.

 Selected Special Shares (SLSDX)
Star rating: 2 Stars
From the  Analyst Report:
Wherever Selected Special roams, it's a keeper. This fund's increasing appetite for larger, classic growth companies in recent years has made it look more like a large-growth fund than a mid-blend offering [its current category]... The fund retains its value investing sensibilities so it will continue to often look out of step with its category. It may look several steps ahead of the average large-growth fund initially, but chances are that'll change if more traditional big growth stocks rally. The fund has delivered strong results since the analysts [of Davis Selected Advisors] took over and is a good go-anywhere fund for patient investors.

Does all this mean you should ignore the star rating? No. The star rating is a good first step in a search for best-of-breed mutual funds, as it takes long-term returns, risk, and cost into account. But the star rating shouldn't be used in isolation. To see the big picture, investors are best off combining the star rating with additional analysis, such as our  Analyst Picks. For further insight into funds that didn't make the list of picks, view our  Fund Analyst Reports.