New Ratings for These 3 Funds

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Morningstar's analyst team is constantly reassessing its ratings on funds. Joining me to discuss some mutual funds that have seen large upgrades so far in 2017 is Russ Kinnel. He is director of manager research for Morningstar.

Russ, thank you so much for being here.

Russ Kinnel: You're welcome.

Benz: Russ, let's just start by talking about the Analyst Rating, how you and the team arrive at the ratings that we assign to various mutual funds.

Kinnel: The Analyst Rating is a forward-looking, fundamental-driven rating that reflects our long-term view of a fund's risk-adjusted prospects. We look at things like the fees, the managers, the performance, the process, the fund company behind that. We talk to the fund managers. We often go out and visit the fund companies. We distill all of that in the Analyst Rating, which goes from Gold with the highest to Silver, Bronze, Neutral and Negative.

Benz: Let's talk about, just real quickly, before we leave the Analyst Rating. It's different from the star rating and there is sometimes some confusion about that.

Kinnel: That's right. If the Analyst Rating is a forward-looking rating, the star rating is purely backward-looking, quantitative measure. The star rating is looking at trailing three, five, and 10-year periods. It risk adjusts those returns and drops them into proportional buckets from 5 stars at 10%, 1 star at 10%, filling in the middle. It's purely quantitative. Any fund with a three-year record gets a star rating, whereas about 1,500 funds get analyst ratings, the full coverage. There's different universe sizes, but the big difference is really forward, fundamental is the Analyst Rating and backward, quantitative is the star rating.

Benz: Good to know. You brought a short list of funds that have recently seen upgrades. Let's start with Fidelity Overseas. It's going from Bronze to Silver. Let's talk about that fund and use it as kind of an example of what sort of catalysts you and the team look at when giving a fund an upgrade.

Kinnel: The catalysts for downgrades are usually a lot more obvious, like, manager leaves or there's some other big issue. It's more subtle on the upgrades. In this case, Montemaggiore hit the five-year mark in his fund and has a very strong five-year performance record. Also, we've now been talking to him for five years about this fund and becoming more comfortable with this process. I think it's really a standout process. Though it goes in the growth bin, his is much more of the Buffett kind of growth, meaning, emphasis on moats, clean balance sheets, strong business models. It's not about just find me the fastest growers based on revenues or earnings. We really like the process as well as the manager and obviously, the results have been strong, too. It's kind of a growing comfort level with all of those things. Of course, I think, five years is when you start to get where the track record is really meaningful.

Benz: This is a fund that in a year like 2017, where you've had the very high growth and certainly, emerging markets among foreign stocks performed very well, this is a fund that is not necessarily going to be a great performer in an environment like that.

Kinnel: That's right. It's not so much of a, kind of, FAANGs kind of fund where you are going to get the really fast-growers necessarily. It's a little more of a steady quality bias that might actually hold up reasonably well in a down market. We don't know for certain because he hasn't been doing that back in the last bear market. But certainly, that quality emphasis is fairly different from the really fast-growing aggressive funds we see.

Benz: Let's talk about another fund that has seen an upgrade. This one as well from Bronze to Silver. That's Harbor Mid Cap Value. What prompted the upgrade in this case?

Kinnel: Yeah. It's a growing confidence story again. I think, in this case, it's quantitative fund subadvised by LSV Asset Management. They run a bunch of quantitative screens that give them sort of a deep value portfolio and really, we just like the consistency of that approach. Fees are reasonable. It's a pretty diffuse portfolio. You are not going to get a lot of stock risk and that's a common trait at quantitative funds because quantitative strategies, they really think it's more about finding the right characteristics. It's not that they are going to find the best names. You end up with a diffuse portfolio, about 190 names, no name bigger than 2%. It's a little different that way. But it's not a bad thing for deep value, because deep value has enough risks on its own.

Benz: This type of fund is something like if you are looking at portfolio and seeing that you have a lot of growth exposure and maybe want to do a little bit of rebalancing, this is the type of product that you might consider in that sort of slot.

Kinnel: That's right. It's been a great time for large growth, especially with the Apples and Amazons growing so strongly. This is very different. Deep value, mid-cap names as opposed to mega-cap growth.

Benz: We've talked about a couple of equity holdings that have seen upgrades. Now, let's talk about a bond fund. Didn't see an upgrade, but it was recently rated, and its rating was Gold. Let's talk about Vanguard Short-Term Inflation-Protected Securities.

Kinnel: That's right. We gave it a Gold right out of the box, which is kind of unusual, but the appeal is really clear. Obviously, really low costs, which is very important for a TIPS fund, because TIPS don't have very big yields to begin with.

Benz: Right. Especially, short-term TIPS.

Kinnel: Especially, short-term TIPS. Any short-term bond fund starts with fees by all means, and this one is very cheap. But it also addresses a real issue with TIPS funds, which is, they are good for protecting against inflation, but not for interest-rate risk, because they tend to have long duration and therefore have some significant interest rate risk.

Obviously, inflation risk and interest-rate risk are related but they are not the same thing. There's times when these longer-dated TIPS can get hurt because interest rates spike more than inflation. This addresses that. Its duration or interest-rate risk is about one-third of the typical TIPS fund. Really a nice conservative little holding. TIPS aren't very tax-efficient. So, I might put this in my IRA or a 401(k) or something like that. But it does a nice job for a very useful role in a portfolio.

Benz: OK, Russ. Thank you so much for being here to discuss the recent upgrades.

Kinnel: You're welcome.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.