These Funds' Strong Star Ratings Don't Tell the Whole Story

Stocks have been volatile this summer, as investors have worried about geopolitical tensions in the Middle East and Eastern Europe, as well as the direction of interest rates and equity-market valuations. 

But as stocks have settled back into a comfortable late-summer groove, I'd say that the biggest threat to most investors' portfolios today is complacency--the tendency to believe that the status quo, especially if it's positive, will persist into the future. As the bear market recedes further and further into the distance, investors may be inclined to forget the merits of risk controls and diversification while front-burnering returns enhancement. 

In last week's Five-Star Investor, I cautioned against throwing worthy risk-conscious mutual funds overboard in favor of funds that have performed better during the five-plus-year equity-market rally. This week, let's take a look at the flip side of that phenomenon: mutual funds that have exceptionally strong recent returns--with 4- and 5-star ratings to match--but that have posted big losses in the past. 

To help arrive at this list, I used our  Premium Fund Screener to search for funds that have 4- or 5-star ratings. However, I screened out funds with track records of more than 10 years, in an effort to isolate those whose high star ratings are based exclusively on their performance over the past three- and five-year periods (and, therefore, don't factor in true bear-market performance). As a refresher, we calculate funds' star ratings by comparing their risk/reward profiles over the past three-, five-, and 10-year periods to those of their peers, but funds with track records of as short as three years can earn ratings, too. 

Within that subgroup, I then screened for those that posted abysmal, bottom-quartile losses in 2008--the last calendar year when truly risky positioning was punished in the market. (The year 2011 wasn't so hot, especially for foreign-stock funds, but most U.S. equity funds managed to end up in the black for the year.) To help ensure that a fund hadn't had a manager change since incurring its outsized 2008 losses (and, therefore, its losses couldn't be chalked up to someone who's no longer there), I screened for funds with manager tenures of seven years or longer. 

Note that not every fund that made this list is a loser: Indeed, one fund,  PIMCO Fundamental IndexPLUS (PIXAX), even garners a Morningstar Analyst Rating of Silver. Nor is the screen meant to suggest that investors should steer clear of every fund that has soared recently but generated outsized bear-market losses. Truly well-diversified portfolios include both defensively minded holdings--the likes of which I featured last week--as well as holdings that can run with the bulls. 

But the exercise is a reminder of the importance of looking beyond near-term performance statistics (that is, those shorter than five years), because they're not at all a reflection of how a fund is apt to behave over a full market cycle. 

To view the screen, click  here. Here's a profile of three of the funds in the screen. 

 Oberweis International Opportunities (OBIOX) 
There's no denying this fund's stunning recent performance: Over the past five years, it has generated a 24% return--good enough to land in the top 1% of its foreign small/mid-growth category, which itself is the best-performing foreign-stock group over that period. The foreign small/mid-growth category has historically been one of the most volatile around, but this fund is racy even by the standards of its aggressive peer group. It invests in smaller companies than its typical peer, while also maintaining a much larger weighting in the technology sector. That aggressive positioning can lead to standout returns, but it also means that when global markets get a cough, this fund gets the flu. Not only did it lose a disastrous 61% in 2008, but it also dropped 15% in 2011. Its standard deviation over the past five years is a sky-high 20, versus 16 for its typical category peer. 

 PIMCO Fundamental IndexPLUS (PIXAX)
This large-cap blend equity fund has been on quite a tear, with returns ranking in the top 25% of its peer group in each of the past five calendar years as well as so far in 2014. Its strategy is a complicated one. It uses swaps to obtain equity exposure in line with the Enhanced RAFI US Large Index. In contrast to traditional market-cap-weighted indexes, which weight companies by market value, RAFI indexes are assembled by looking at fundamental factors such as companies' dividends and cash flows. Because obtaining the equity exposure via swaps requires only a small amount of collateral, manager Bill Gross invests the rest of the assets in a fixed-income portfolio along the lines of  PIMCO Unconstrained Bond (PFIUX). The fund has adjusted its strategy somewhat since it lost 44% (six percentage points more than the S&P 500) in 2008. In that year, its rapidly falling equity portfolio triggered margin calls on some of its swaps, forcing PIMCO to unload beaten-down bonds into a falling market. Adjustments since then could help it avoid a repeat; for example, RAFI tweaked the equity index to downplay firms with the potential for financial distress. But nor is the fund without risks: A recent adjustment to the fund's fixed-income mandate means it can now hold 20% in high yield and 25% in emerging-markets bonds, and senior fund analyst Eric Jacobson notes that its fixed-income portfolio has historically taken on more credit risk than  PIMCO Total Return (PTTAX). That flexibility could serve it well in a challenging bond market, but the fund could also get caught leaning the wrong way. 

 Thornburg Global Opportunities (THOAX)
The world-stock category encompasses a broad range of investment styles, from tame offerings such as  Tweedy, Browne Value (TWEBX) to more aggressively positioned funds like this one. This fund skews more heavily toward small- and mid-caps than its average world-stock peer and also tends to hold more in emerging markets. Its managers don't shy away from concentrated positions, either, both in terms of individual stock weightings as well as sectors. Most recently, the fund has emphasized technology stocks, but the financials sector has been a favorite hunting ground in the past. Senior analyst Karin Anderson called it a "fair-weather performer," and the fund's showing since the end of the financial crisis attests to that billing: Its 16% five-year annualized return lands in the world-stock group's top echelons. Thornburg also boasts a strong, investment-centric culture, and comanager Brian McMahon also works on the Bronze-rated  Thornburg Income Builder (TIBAX). But the fund's terrible showing in 2008, when it lost nearly half of its value, demonstrates that its bold positioning can have a downside.

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