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Great Funds with Low Star Ratings

Don't rule out these Analyst Picks with 3 stars or less.

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One of the most common queries Morningstar's fund analysts are asked is "Why would you pick funds that only got 3 (or 2) stars?" This question partially stems from a common misunderstanding about the Morningstar Rating for funds and our Analyst Picks. The star rating is a strictly objective measurement of a fund's historical, risk-adjusted returns versus its category peers. In contrast, Analyst Picks are subjective, forward-looking judgments, often with an eye toward portfolio construction.

Choosing Analyst Picks is a rigorous process. One Morningstar fund analyst covers each Morningstar category and thoroughly reviews those funds once every five months. As part of the review, the analyst chooses a few funds that he or she believes are most likely to do well in investors' portfolios. The analyst then must defend these funds to the fund analysis group's senior management, who are tough customers. This experienced bunch cares less about hot past performance and more about reasonable expenses, sound strategies, attention to risk, and stable management.

It's no coincidence that of the 17 funds in the Morningstar 401(k) plan (click here to see Emily Hall's recent update on it), nine are now Analyst Picks and three were picks before recently closing. And these funds are in the 401(k) plan because they're picks, not the other way around. Three funds in our 401(k) plan currently have only 3 stars-- Turner Mid-Cap Growth (TMGFX),  Tweedy, Browne Global Value (TBGVX), and  Morgan Stanley Institutional US Real Estate (MSUSX). All of them are fairly steady performers in areas where many funds are volatile in both absolute and relative terms. Thus, they're still quite attractive. A fourth pick in the Morningstar 401(k) plan now holds only a 2-star rating-- American Funds New World (NEWFX), an emerging-markets fund. It lagged in the recent, red-hot emerging-markets rally because of its perennial 25% investment in developed markets and 10% cash stake. But those allocations also provide stability, a quality we appreciate, in a category whose losses can be steep.

To see other Analyst Picks that have 3-star or lower ratings, we can create a simple screen in the  Premium Fund Screener. First, we'll choose all the Analyst Picks. Then we'll look for funds whose star ratings are less than or equal to 3 stars. Finally, just to make sure that expenses are low, we'll demand to see funds whose expense ratios are lower than the average fund in their categories.

This screen yields 27 funds. The funds mentioned above passed our screen as of March 31, 2004. The results of the screen may change because of daily price fluctuations or other factors. Click  here to run it for yourself.

No one theme connects all these picks, although there are a few common elements in the group. We'll look at just three funds that exemplify some of the most important traits.

 Vanguard Total International Stock Index (VGTSX)
Many experts contend that indexing doesn't "work" overseas, because good managers can add value in less-efficient markets. Nonetheless, this fund does offer the broadest, and hence most-diversified, exposure to foreign stocks that one can get. Just as important, its 0.19% expense ratio gives it a huge head start on its category peers, whose expenses average 1.69%. That's part of the reason why, over the trailing five years through March 30, 2004, the fund's returns have actually edged out nearly two thirds of its peers.

 Northern Technology (NTCHX)
This fund has average returns and slightly below-average volatility compared with its sometimes-reckless specialty-technology category peers. The fund's sensible strategy, which emphasizes blue-chip firms such as  Cisco (CSCO) and  Intel (INTC), is a key reason for that standing. Plus, lead manager John Leo has been in charge since the fund's inception in 1996. That's a 7.3-year manager tenure, nearly doubling the average tech fund's 3.8-year mark. Finally, while the fund's 1.25% expense ratio isn't exactly cheap, it's better than its average peer's 1.99% cost.

 FPA Capital (FPPTX)
Manager Bob Rodriguez is the only winner of Morningstar's Fund Manager of the Year award in both the Equity and Fixed-Income divisions. That rarefied standing largely stems from his hatred of losing money, which has given this fund a remarkable record. It's had only four annual losses, and only one of those a double-digit loss, in the 20 years since Rodriguez took charge. It also means that you won't pay much at all for his expertise--the 0.87% expense ratio is the lowest for actively managed funds open to all investors in the small-value category.

Todd Trubey does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.