Anatomy of a Neutral Analyst Rating

Morningstar recently updated the Morningstar Analyst Rating for  Baron Asset (BARAX)--keeping its Neutral rating at Neutral. That's not headline news, but it is worth exploring further because this is not a typical case. There is a lot to like about this fund: It gets a Positive for both the People and the Process pillars of the rating. (There are five pillars overall, with the others being Performance, Parent, and Price). A strong manager employing an intelligent strategy is often the recipe for success in active management.

In fact, it is rare that a fund boasts both attributes yet ends up with a Neutral rating. Of the 607 actively managed U.S. open-end funds that score Positive on both People and Process, 96% were Morningstar Medalists. The rest, just 4%, were rated Neutral (and none were Negative). In comparison, 28% of all actively managed U.S. open-end funds that we've rated have a Neutral rating.

Weak Pillars Offset Strong
In the case of Baron Asset, its Neutral rating does not result from lack of management experience or commitment. Andrew Peck started at Baron as an analyst in 1998, became comanager of the fund in 2003 (working alongside firm founder Ron Baron), and took over in 2008. He has aligned his interest with shareholders by investing more than $1 million in the fund. Peck is also backed by Baron's strong analyst team.

What's more, Peck follows an established Baron strategy that is generally a successful one: The three other Baron funds Morningstar covers earn Analyst Ratings of Bronze. He looks for long-term secular growth characteristics, a sustainable competitive advantage creating predictable growth, great managers, and reasonable debt levels relative to industry peers. The end result is an attractive portfolio by many measures. As of March 31, 23% of the portfolio was in wide-moat companies by Morningstar's measure, and only 14% had no moat. That's good for a mid-cap growth fund (the category norm is 17% and 23%, respectively). The portfolio also shows a significantly higher net margin, return on assets, and return on equity than the category average, without a higher debt/capitalization ratio.

So, what's holding the fund in Neutral? Partly the Performance pillar. During Peck's solo tenure on the fund (starting in early 2008), the fund's returns have been near the mid-cap growth norm. The fund's Risk ratings are also average, even though the portfolio is relatively high quality. That may be because the portfolio is also pricier than its average peer. Peck is willing to hold on to favored picks as long as their valuations are supported by his estimate of their intrinsic value, which he calculates with the long view in mind.

Price is also a key issue: In this case, a higher-than-average expense ratio of 1.33% is a headwind. (The median for no-load mid-cap funds is 1.11%.) Other Baron funds have overcome a similar expense obstacle, but this one has not. It would be better positioned to outperform if its costs were lower.

Cost Is Key
Price is so significant a factor that high fees can be determinative when it comes to the Analyst Rating.  Wasatch Emerging Markets Small Cap (WAEMX) earns an overall Neutral Analyst Rating despite Positive scores for People, Process, Performance, and Parent. Its downfall is an expense ratio of 1.95%, extremely high even for an emerging-markets fund. What's more, with a management fee of 1.75%, there is only so low expenses can go.

That is a dramatic example--cost is not typically the only factor that keeps a fund from being a Medalist. It is, however, the most common drawback among the relatively few Neutral funds that merit Positive scores for both People and Process. Take  Wasatch Global Opportunities (WAGOX). Managers J.B. Taylor and Ajay Krishnan have good track records at other Wasatch funds, and they use the same process that drives the success of Wasatch's other international offerings. However, recent manager changes make it hard to attribute strong past performance to the current team--and expenses are well above the norm.  Marsico Focus (MFOCX) and  Marsico Growth (MGRIX) are run by Tom Marsico, who has a long record of success picking growth stocks with overall positioning guided by macroeconomic themes. But high expenses, in addition to turmoil at Marsico Capital Management, keep the funds at Neutral.

As expenses are one of the best ways to predict future relative returns, it makes sense that high costs are a high hurdle to becoming a Morningstar Medalist.

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