Vanishing Stars Need Not Cause Alarm

If you're like many investors, you probably feel at least a small dose of pride when you see that funds you own have outperformed the competition over time. Seeing those 4 or 5 stars next to your fund's name may, in fact, make you feel pretty confident that your money's in capable hands as evidenced by the fund's superior performance (ignoring, at least for the moment, the fact that past performance is no guarantee of future results).

But sometimes Morningstar Ratings for funds (the official name for our star rating method) change rapidly because of significant market events--such as the 2008 financial crisis--or when such events recede far enough into the past. We're currently experiencing this latter phenomenon as some of 2008's heaviest losses fall out of the five-year performance window that plays a major role in determining a fund's overall star rating. As discussed in this recent Five-Star Investor article, some funds hit hardest by the market turmoil that accompanied the financial crisis have begun looking better as five-year trailing returns start to reflect more of the rebound from the bear market and less of the downturn.

But just as some funds' star ratings have improved as a result, others that didn't fall nearly as far in 2008 have seen their ratings drop because they rebounded less during the recovery. We're talking about funds that may have outperformed on the downside, but with that downside becoming increasingly less important in the Morningstar Rating calculation, they are at a disadvantage relative to peers that rebounded more.

Take, for example,  American Century Equity Income (TWEIX), a large-value fund that carries a Silver Morningstar Analyst Rating. The fund tends to take a conservative approach, making it less volatile than its peers, as shown by its low Morningstar Risk rating and the fact that it lost just 20.1% in 2008, which was about 17 points better than its average peer. But the fund's strong 2008 performance is diminishing in importance in the star rating methodology, taking with it some of the fund's stars. As a result the fund, which began 2013 with a 5-star rating, now carries just 3 stars. But it's not the fund's manager or process that's changed. It's the calendar (though a lousy 2013 hasn't helped matters).

The point is that looking at a fund's star rating in a vacuum can lead one to some erroneous conclusions. A 5-star fund can become a 3-star fund rather quickly and vice versa in the wake of a market calamity like we saw five years ago. That's why looking beyond the stars--at how the fund performed in different market environments such as the 2008 bear or the 2013 bull as well as at its management team and strategy--is necessary in order to get a fuller understanding of how it can be expected to behave in the future.

Previously we looked at funds that had the biggest increases from their risk-adjusted 2008 performances to their annualized risk-adjusted performances since then. This week we look at funds with the smallest increases during those time periods. We use risk-adjusted returns for this exercise because they are used in calculating the star rating. Risk-adjusted returns measure a fund's performance relative to the amount of risk it took on, so if two funds each returned 10%, the fund that did so with less risk will have a better risk-adjusted return. Funds' risk-adjusted returns may vary quite a bit from their actual returns. You can read more about Morningstar's risk-adjusted return and star rating methodology in this document. Finally, only equity funds with at least $500 million in assets currently were considered for the chart.

Equity Funds With Smallest Performance Improvement Since 2008
	Analyst Rating	2008 Risk-Adj. Return (%)	2009-13 Risk-Adj. Return (%)	% Point    Change	Star Rating	2013 Change in Star Rating
Intrepid Small Cap (ICMAX)	N/A	-10.4	13.7	24.2		-1
First Eagle Gold (SGGDX)	Und Rev	-35.0	-8.7	26.3		None
EV Wldwd Hlth Scn (ETHSX)	N/A	-17.9	11.9	29.8		None
Fidelity Select Gold (FSAGX)	Bronze	-47.0	-14.6	32.5		None
Am Cent Eq Inc (TWEIX)	Silver	-23.3	10.4	33.7		-2
Heartland Value Plus (HRVIX)	Bronze	-23.8	12.6	36.5		-2
First Eagle Ovrseas (SGOVX)	Silver	-28.5	8.9	37.4		None
Putnm Gbl Hlth Care (PHSTX)	N/A	-25.9	11.6	37.4		None
Gabelli Utilities (GAUAX)	N/A	-28.3	9.2	37.5		-1
Fidelity Selct Biotech (FBIOX)	Bronze	-17.1	21.2	38.3		-1
Vngard Hlth Care (VGHCX)	Gold	-22.8	15.8	38.6		None
Royce Special Equity (RYSEX)	Gold	-23.9	14.8	38.7		None
Franklin Biotech Disc (FBDIX)	N/A	-20.9	18.0	38.8		None
Amana Inc Inv (AMANX)	Silver	-26.3	12.7	39.0		-1
Perkins Sm Cap Val (JNPSX)	Silver	-27.0	13.1	40.1		-1
Tweedy, Browne Val (TWEBX)	Silver	-27.9	12.3	40.2		None
BBH Core Select	Silver	-25.5	14.8	40.3		None
Fidlty Slct Cns Stpls (FDFAX)	Bronze	-26.4	14.6	41.0		None
JHancock Reg Bank (FRBAX)	N/A	-36.3	4.8	41.2		None
Intg Wln Bsn/Mid-NA (ICPAX)	N/A	-30.1	11.1	41.2		-1
All results as of Oct. 31, 2013. Funds have minimum $500 million in assets. 2009-13 risk-adjusted returns are annualized.

A peek at the previous list and the one above shows a notable difference in the extent to which funds lost value in 2008. Among those that rebounded the most and thus added stars (in some cases), the 2008 risk-adjusted losses ranged from -57% to -75%. Among those that rebounded the least, risk-adjusted losses that year ranged from -10% to -47%. Clearly, the size of the drop and the size of the rebound often were closely related.

Last, it's interesting to note the preponderance of sector funds on our latest list, and health-oriented funds in particular. The category lost just 23.4% on average in 2008, making it one of the better-performing equity sectors that year and helping to explain why many of the funds in it rebounded less than funds from harder-hit sectors.