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Low-Quality Funds with High Star Ratings

Funds with high star ratings don't always win our favor.

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Morningstar fund analyst Dan Culloton doesn't much like  Jacob Internet (JAMFX), despite its 2003 return of 101%. In fact, the fund has the dubious distinction of being the only fund with a 5-star rating now included on our Analyst Pans list.

Many might wonder how a fund with 5 stars could earn the scorn of a Morningstar mutual fund analyst. Culloton's explanation is simple: Over its lifetime the fund has lost more than 30% annually, it’s a highly volatile fund even compared to its highly volatile category peers, and it's very expensive. A high price tag, above-average volatility, and heavy losses--that's a recipe to avoid. The fund earns its 5-star rating in an interesting fashion, by the way. Having been around for fewer than five years, its rating looks only at the trailing 36 months. Thus, its very hot run from late 2002 through early 2004 overwhelms its poor absolute and relative performance that came before. As we say at Morningstar, no one data point--not even the Morningstar star rating--ever tells the whole story.

While Jacob Internet is the only 5-star Analyst Pan, there are a few 4-star Analyst Pans that you can find with a very quick search: Simply screen for Analyst Pans and a Morningstar Rating of greater than or equal to 4 stars using the  Premium Fund Screener.

To run this screen, click  here.

While such a list is interesting, it doesn't necessarily do the whole trick. Ideally, you'd like to figure out how to avoid potentially dangerous funds with high Morningstar Ratings on your own. There are a few different ways to do this, but one elegant way starts by describing a 4-star fund that you wouldn't want to own (and keep in mind that there are many different descriptions you could create). Consider a fund in a hot, narrow category, with above-average expenses and above-average risk. Such an offering could have a great recent run but would be a potentially poor long-term choice.

To build such a screen, first we've selected only funds with ratings of 4 stars or above.

Next, we'll go through a short list of categories that are fairly small and have been sizzling lately: Foreign Small/Mid Value, Foreign Small/Mid Growth, Japan Stock, and Latin America Stock. We'll also throw in the grab-bag Specialty Stock (all) to include all sector funds, which can be quite volatile and pricey. (Note that when you're linking together a bunch of categories, you want to choose the "or" connector between them, not the "and" connector.)

After that, we'll request funds whose expense ratios are above the category average and whose Morningstar Risk score is above average.

To run this screen yourself, click  here. As of April 30, 2004, it yields 26 funds.

Now, not all of these funds are truly problematic. For instance, State Street Global Resources  (SSGRX) is a natural resources fund. Because it focuses on small- and micro-cap stocks, it's volatile and a bit expensive. That said, manager Dan Rice has managed the fund for a long time and is a good stock-picker.

We'll highlight three funds that we would avoid:

 Evergreen Health Care (EHABX)
This fund's been around only for about four years and has posted above-average returns every year. So what's not to like? In addition to fairly high turnover, its expense ratio for the A shares is over 2% and has actually increased as assets have grown. In a category that has plenty of cheaper peer funds with long, solid records, we'd go elsewhere.

 Merrill Lynch Latin America (MCLTX)
This is one of those tricky funds where one share class, the C shares, gets a better star rating than the A and B shares. That's because this share class hasn't yet been around long enough to have its recent performance be brought down a 10-year rating, as the A and B shares have. Certainly this fund has been able to achieve eye-popping returns, like a 70% leap in 1999 and a 67% jump in 2003. But the fund is on its third management team in four years. That, plus high volatility and high expense ratios across the share classes, means we'd steer clear.

 Morgan Stanley Health Sciences (HCRAX)
This fund has posted above-average returns with average risks over its six-plus years. But in the bear market, much of the fund's strength came from health devices, which held up better than other health-care stocks. But the comanager in charge of devices, Peter Dannenbaum, left, and now his former comanager, Alex Denner, is flying solo. Given that Denner covers the small biotech area and that one of the three analysts on the portfolio is new to health care, we think investors can find a more promising offering.

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