Narrowing the Gap
Can the new Morningstar Analyst Ratings help investors pocket a bigger share of funds' gains?
Fund Spy
The new Morningstar Analyst Ratings and Global Fund Reports are designed to help all investors--individuals, institutions, advisors, retirement plan administrators, and other gatekeepers--use funds more effectively. Individual and institutional investors alike often pile into a fund after it posts huge gains and head for the exits when a fund hits the skids, thus locking in losses. As we've written about before, there's often a wide gap between a fund's total returns and its Morningstar Investor Returns, which factor in inflows and outflows. This gap suggests that investors are leaving a big chunk of funds' gains on the table. The gap is often wider for funds whose performance is volatile, suggesting that investors may not have understood a fund's risks when they bought the fund or may not have had reasonable expectations for the fund's performance in certain market conditions.
The Morningstar Analyst Ratings can help improve investors' results by helping them understand and set reasonable expectations for their funds. A good overall rating and positive People and Process scores might help investors stick with a slumping fund and capture its rebound and long-term gains. A poor rating can help others resist the temptation to chase a fund on an unsustainable hot streak. Below we profile a few funds where the difference between the fund's annualized total return and investor return (here called the "Returns Gap") is wide enough to drive a truck through. Ideally, over time these are the kinds of situations in which the Morningstar Analyst Ratings can help.
Morningstar Analyst Rating 5-Year Total Return % (annlzd) 5-Year Investor Return % (annlzd) Returns Gap % (annlzd) Loomis Sayles Strategic Income (NEFZX) Gold 5.9 2.9 3.0 Weitz Value (WVALX) Silver -3.4 -6.3 3.0 Oppenheimer MainSt Sm&MidCp (OPMSX) Neutral -0.8 -4.2 3.5 Legg Mason Cap Mgmt Growth (LMGTX) Negative -7.4 -11.3 3.9 Source: Morningstar Direct, as of Dec. 19, 2011.Know Why to Stick With It
Investors fled multisector-bond fund Loomis Sayles Strategic Income (NEFZX) in droves after its 23.2% loss in 2008. The fund saw roughly $1.2 billion in outflows between September and December 2008. Those who left missed the fund's rebound, a top-decile 19.7% annualized gain over the trailing three years through Dec. 19.
The volatile fund earns a Gold Morningstar Analyst Rating because of its deep and experienced management team. Skippers Kathleen Gaffney, Dan Fuss, Elaine Stokes, and Matt Egan focus on higher-yielding bonds and non-U.S.-dollar fare with the goal of delivering a beefy income stream. Those areas tend to sell off in risk-averse markets, but the team keeps a stake of cash and government bonds on hand to lessen the risk of having to sell bonds into less-liquid markets and as dry powder to use on bargains. That aspect of its process and management's proven credit expertise have fueled the fund's topnotch long-term performance both in terms of income and total return. The fund is aggressive, with no limits on high-yield or non-U.S. exposure and the leeway to park up to 35% of assets in common and preferred stock. Its performance is likely to remain volatile, but the fund is a great offering for income-oriented investors ready to ride out its periodic rough patches.
The large-value fund Weitz Value (WVALX) suffered a harsh blow in 2008, too. It lost 38.1% that year as manager Wally Weitz's positions in financial stocks, including Fannie Mae (FNMA), Countrywide Financial, and American International Group (AIG), plunged. The fund investors who sold the fund when it was in net redemptions between March 2007 and September 2011 weren't around when the fund bounced back and made the offering's five-year investor returns of negative 6.3% almost double the fund's time-weighted 3.4% loss.
Weitz's contrarian style has never been for the faint of heart. But the fund's Silver Morningstar Analyst Rating and Positive People and Parent scores reflect high regard for his team and for the firm's stewardship. Weitz and his colleagues are heavily invested in their funds, as are many of the fund's independent board members. Having skin in the game helps align management's incentives with fund shareholders, as does its willingness to close funds if they get too big. The fund's Positive Performance score doesn't overlook 2008 and is supported by the observation that Weitz's funds have had dry spells in the past. That means investors need to hold tight or consider doubling down when the fund stumbles. The fund's Negative Price score (for high fees) remains the main strike against it.
Know When to Leave
In contrast to Weitz's relative stability, Oppenheimer Main Street Small & Mid Cap (OPMSX) is struggling to find its footing. The fund's 38.2% loss in 2008 landed in the small-blend category's bottom third, and since then it has experienced two changes in strategy and two manager changes. Since May 2009, management of the fund has been split between two teams, one fundamental and one quantitative. In late 2010 it expanded its mandate to include mid-cap stocks. In the background, parent Oppenheimer Funds has been working to overcome the risk-management debacle that derailed a number of its fixed-income funds in 2008. All told, the firm's challenges and this fund's multiple changes have driven many investors away, and the fund has seen $2.4 billion in outflows since October 2008 through November, or roughly 45% of its assets.
They may be onto something. The fund's ragged history might argue for a Negative rating if its relatively new management didn't show promise. Given the tumultuous past few years, the fund's Neutral rating stems primarily from its Positive People score. The fundamental side of the portfolio is comanaged by Raymond Anello and Matt Ziehl. Although Anello only stepped into the comanager role in April 2011, Ziehl
racked up an attractive track record at RS Small Cap Equity (GPSCX) from 2002 to 2009, and the broader team generated attractive results at RS Large Cap Alpha (GPAFX) before taking over the Bronze-rated Oppenheimer Main Street (MSIGX) in 2009. It remains to be seen if the team can generate similar results here, yet the fund's annualized 17.3% return since it took over in May 2009 outpaces 85% of the fund's rivals and suggests the team's higher-quality approach can help it weather rocky markets. While the Neutral rating suggests the fund's potential, it's tough to have greater conviction in it at this point.
Sometimes the Morningstar Analyst Rating provides greater conviction to seek greener pastures. The 7.4% annualized loss and negative 11.3% investor return of Legg Mason Capital Management Growth Trust (LMGTX) bring up the large-growth category's rear. Investors poured into the fund on the heels of its chart-topping gains in the early 2000s, only to get socked by lackluster relative returns in 2005 and 2006, then a chart-bottoming 60.4% loss in 2008. The fund has lost roughly 40% of net assets to outflows over the trailing five years, reflecting investors' waning confidence.
The fund's Morningstar Analyst Rating offers little reason to stick it out. None of its pillar scores is Positive. Its People score is Negative, reflecting its management's spotty execution of its strategy over its 16-year tenure. Its Process scores a Neutral because of several changes to the fund's strategy under its current management. Some of those changes, such as a less concentrated portfolio and less emphasis on the tech sector, appear to have benefited performance somewhat, as the fund's 14.4% annualized gain over the trailing three-year period has helped dig the fund out of its hole. Yet uneven performance across the firm's nine asset management subsidiaries creates some organizational uncertainty and contributes to its Neutral Parent score. Better options beckon.
Tune Out and Tune In
These aren't the only funds in which investors aren't having the best experience they could. When a fund's performance is volatile, markets noisy, or investors tempted to rashly buy or sell a fund, the Analyst Ratings can help investors tune out the noise and act on the fundamentals backing a fund rather than emotion. Tuning into those fundamentals should improve investors' experience and help them use more effectively over the long haul.
