These Formerly 'Fantastic' Funds Now Miss the Mark

A version of this article was published in the June 2015 issue of Morningstar FundInvestor. Download a complimentary copy of FundInvestor here.

In yesterday's Fund Spy, my colleague Russel Kinnel discussed his annual search for the mutual fund industry's strongest offerings. The strict quantitative test highlighted 50 of the best funds, which he then dubs "Fantastic."

The list of Fantastic funds is fairly stable from year to year, but about a dozen funds included in 2014's roster didn't make the cut in 2015. Among those that exited, two were dinged for their expense ratios, two missed the mark following manager changes, and four funds were cut after long-term performance fell off.

Are these deteriorations significant enough to warrant replacing the fund in one's portfolio? In all but one case, the funds still earn Morningstar Analyst Ratings of Gold, Silver, or Bronze, signaling our conviction that they will outperform going forward. One fund was downgraded to Bronze from Silver, and another fell one notch to Neutral, suggesting the funds have significantly steeper climbs.

Less Competitive on Price Two funds previously deemed Fantastic were dropped because their expense ratios went up. While a basis point or two may disqualify a fund from the Fantastic list, the fees on these funds are by no means alarming.

This world-allocation fund's expense ratio has moved around slightly in recent years, from as low as 0.55% heading into the financial crisis to a high of 0.66% in 2009. The fund had been treading in the middle of that range in recent years, and in 2014, the fund's levy ticked up 1 basis point to 0.62%.

Even with that 1-basis-point move, the fund is still a relatively good deal. It retains its Analyst Rating of Silver--including a Positive Price Pillar rating. It is the largest offering in the world-allocation Morningstar Category by a long shot, and its experienced management team recently split the fund's assets between two internal, yet independent, investment teams to better steer the fund's equity stake. The fund's performance has been strong, thanks in part to a higher equity stake relative to peers.

This fund also missed the Fantastic list because of a higher expense ratio, but the change in cost is related to the fund's strong past performance. Fidelity is one of a few large asset managers that has performance fees on many of its funds, where the expense ratio ticks up after a period of outperfomance or goes down if the fund has trailed its benchmark.

Morningstar supports such fulcrum fees, so long as the fee swings are modest. In the case of this large-growth fund, the expense ratio goes up 2 basis points for every percentage point the fund's annual return exceeds its benchmark, the Russell 1000 Growth Index. In 2013, the fund outpaced that index by 2.47 percentage points, upping the expense ratio by 4 basis points to 0.81%. This increase moved the fund's expenses beyond the category's cheapest quintile, but the fund still earns a Positive Price Pillar rating, and the offering overall is rated Bronze. Expect expenses to continue to bounce around: Manager Fergus Shiel's bold bets are off at times, but long-term performance is impressive.

Manager Changes Put Funds in Flux Fund manager departures can be unsettling, especially if the new manager on the fund is untested. Two funds previously on the Fantastic list passed the baton in 2014 to a manager with less than five years of experience on the fund.

Brian Rogers, skipper of this large-value fund for 30 years, is retiring in October, a move well-forecast in typical T. Rowe fashion. John Linehan, the firm's former head of U.S. equities, will take over the low-turnover portfolio. Linehan is an experienced manager, having comanaged T. Rowe Price Institutional Large-Cap Value TILCX with Rogers since 2004.

Linehan's newcomer status to this particular strategy, however, eliminates the fund from the Fantastic list. Morningstar has maintained a Bronze rating on the fund, demonstrating confidence that Linehan is well-equipped to manage the transition.

This foreign large-growth fund also got a new manager recently, but Richard Clattenburg, taking over for Bob Smith after eight years on the fund, is less experienced. Clattenburg has been a named comanager on the fund since 2010 and can lean on Smith throughout 2015.

This offering still has its strong points, including reasonable fees and an experienced team of analysts and portfolio managers. But Morningstar has lowered the fund's Analyst Rating to Neutral to reflect a lower level of conviction in Clattenburg's ability to run the show successfully.

Performance Has Dipped The returns test for the Fantastic funds is a strict one. The offerings need to beat their prospectus benchmark over the lead manager's tenure, a test that's typically tougher than clearing a category average.

This large-value fund's sturdy portfolio fell behind the benchmark in 2014 by 0.84 percentage points, which is a relatively small shortfall and still strong enough to finish in the category's top decile. Even so, the benchmark shortfall put the fund a hair behind the Russell 1000 Value Index for the period beginning in January 2006, the start date for the fund's longest-serving managers.

Fundholders have good reason to stick around, however. The fund still receives a Gold rating for its proven, dividend-focused approach, reasonable fee, and tested management team. The strategy has lagged in some more-speculative rallies and holds up best during market declines, such as 2008. This one is a keeper.

Longest-serving manager Dennis Bryan put up strong relative returns at this mid-value fund in the four years after he joined the management team in November 2007, but this fund fell behind in 2012 and has had trouble picking itself back up. It trailed the Russell Midcap Value Index by double digits in 2013 and 2014, erasing the fund's impressive gains coming out of the financial crisis.

This fund is no stranger to periods of underperformance, but the current management team hasn't endured a similar period. As such, Morningstar downgraded the fund in May 2015 to Bronze from Silver, a sign of waning conviction. Patient investors are likely to fare well here over the long term but don't expect a smooth ride.

This moderate-allocation offering was subject to a new performance test for the 2015 Fantastic list. Previously we considered longtime manager Bill Frels' record, but when he retired at the end of 2014, performance rested with comanager Ron Kaliebe, who has been assigned to the fund since 2006.

Performance during Kaliebe's tenure has been strong overall, but the fund did trail the benchmark in five of the nine calendar years. Morningstar has maintained a Silver rating on this fund through the management change, indicating conviction in Kaliebe's ability to maintain the fund's prudent approach. The investment process stresses sustainable competitive advantages and above-average earnings growth.

One of our favorite funds, Gold-rated Vanguard Wellington, fell out of the Fantastic 50. The reason is that its returns since the end of 2002 now lag the S&P 500. Yes, an allocation fund with a pure equity benchmark has a very high bar to overcome, but those are the rules we set out. Wellington's past 12 months saw the fund produce returns that were about half of those of the S&P 500. That was pretty good for its peer group but not enough to keep it ahead from the beginning of Ed Bousa's tenure. So, it is out of the Fantastic 50 but still an excellent choice.