Stars Aligning for Some Funds Hit Hard in '08

Most investors have been only too happy to put 2008 in the rearview mirror. But for managers whose funds fared particularly poorly during the raging bear market sparked by the financial crisis, the next few months are likely to provide a long-awaited sense of relief, if not cause for celebration. That's because some of the harshest equity performances of that time period will finally disappear from funds' five-year annualized return numbers, a key measure of a fund manager's performance.

The S&P 500 lost 37% in 2008, the bulk of that loss taking place after Labor Day, and we've already seen some funds improve their Morningstar Ratings as a result of their September-October 2008 performance numbers falling out of the five-year window. In fact, according to Morningstar research, October 2013 saw about 10 times the normal number of changes to the five-year Morningstar Rating across all fund types and share classes, with star ratings improving in about two thirds of those cases. 

To review, the Morningstar Rating for funds is calculated based on how a fund performed on a risk-adjusted basis relative to its peers during the trailing three-, five-, and 10-year periods. For funds that have been around for at least five years but fewer than 10, the five-year return accounts for 60% of the star rating; for funds that have been around a decade or more, the five-year return accounts for 30%. (You can read more about the Morningstar Rating methodology here.) With five-year performances starting to look a lot better because of the passage of time, some funds stand poised to improve their star ratings--that is, how the funds' performance stacks up against peers from the same category.

A great example is  Longleaf Partners (LLPFX), a Silver-rated large-blend fund whose managers use a deep-value, high-concentration approach. The fund got hammered in 2008 to the tune of a 50% loss and a 97th percentile performance in its category. As a result, the fund, which carried 4 stars in the early part of the year, ended it with 2 stars before dropping to just 1 star in 2012. In recent weeks, however, as the fund's dismal late 2008 showing has begun to fade in the distance, its star rating has jumped up to 3 stars. As of Nov. 11 the fund's five-year annualized return of 21.8% put it in the 4th percentile of its category, while its 10-year average return, which includes all of 2008's poor performance, stood at 6.1%, landing it in the 82nd percentile. Not all of this long-term performance lag is attributable to 2008--the fund also underperformed badly in 2004, 2005, and 2007. But its quickly improved five-year record clearly deserves the lion's share of credit for the fund moving from 1 star to 3 stars in such a short time period.

Of course, the market didn't reach a bottom until March 2009, so the impact of the bear market won't fully roll off of five-year returns for another several months. But putting some of their darkest days in the past should be a boon to funds that had particularly bad showings at the time but which have since rebounded. To identify some of these funds, we've compiled a list of funds that have the biggest gaps between their 2008 performances and their annualized performances ever since (through Oct. 31, 2013). Although many funds on the list have added or will soon add stars to their Morningstar Ratings as their late 2008 performances become less important, that's not always the case. After all, five-year performance is only part of the Morningstar Rating formula, so funds with poor three- and/or 10-year records may not be adding stars, at least not yet.

Equity Funds With Biggest Performance Improvement Since 2008
	Analyst Rating	2008 Risk-Adj. Return (%)	2009-13 Risk-Adj. Return (%)	% Point    Change	Star Rating	2013 Change in Star Rating
Opnhmr Intl Sm Co (OSMAX)	N/A	-74.7	25.1	99.8		+1
Wasatch EM Sm Cp (WAEMX)	Neutral	-64.7	22.2	86.8		None
PIMCO Rl Est Rl Ret (PETAX)	N/A	-70.7	15.6	86.3		-1
Legg Mason Opp (LMOPX)	Neutral	-71.2	14.1	85.3		None
T. Rowe New Asia (PRASX)	Bronze	-68.0	16.5	84.5		+1
Fidelity Slct Engy Srv	N/A	-74.4	9.2	83.6		None
Fidlty Intl Sm Cp Op (FSCOX)	N/A	-66.0	16.4	82.4		+1
Wasatch Intl Gr (WAIGX)	Bronze	-60.2	22.0	82.1		None
William Blair EM Gr (WBENX)	N/A	-69.7	12.3	82.0		+1
Henderson Euro Foc (HFEAX)	N/A	-64.6	17.5	82.0		+1
Mrgn Stnly Foc Gr	Gold	-60.3	21.7	82.0		+1
Fidelity Lev Co Stk (FLVCX)	Silver	-63.4	18.3	81.6		None
Fidelity Slct Tech (FSPTX)	Neutral	-58.8	21.3	80.1		None
Tchst Snds Cp Sl Gr (PTSGX)	Bronze	-54.2	25.9	80.1		None
Janus Venture (JANVX)	Neutral	-57.0	22.3	79.3		None
Invesco Euro Sml Co (ESMAX)	N/A	-61.9	17.3	79.3		None
Fidelity Pacific Basin (FPBFX)	N/A	-62.4	16.6	79.0		+1
T. Rowe Med & Tel (PRMTX)	Bronze	-53.0	25.5	78.5		-1
T. Rowe EM Stk (PRMSX)	Bronze	-68.2	10.3	78.5		+1
AllianceBern Disc Gr (CHCLX)	N/A	-56.8	21.4	78.2		None
All results as of Oct. 31, 2013. Funds have minimum $500 million in assets.

One final word of caution: Just because 2008 fund performances will soon have less of a bearing on funds' star ratings, that's no reason to dismiss them in your own analysis of a fund. Painful as it was, 2008 was a great stress test for any fund, and looking back at how a fund did that year can still be instructive with regard to how it might perform should the unthinkable happen again.