Solid Funds with Heady Risk Scores
Risk-tolerant investors may need to look beyond the stars.
We designed the Morningstar Rating for funds in order to suit the average investor. As you probably know, the star rating measures a fund's risk-adjusted performance versus category peers over the trailing three-, five-, and 10-year periods. The return component is fairly straightforward, but the assessment of risk merits some explanation. For the purposes of the star rating, risk is not defined simply as negative returns, as volatility, or as underperforming peers. Rather, the risk calculation examines all variations in a fund's monthly performance, emphasizing downward variations. The star rating thus rewards consistent performance and penalizes erratic behavior.
Some investors can handle more investment risk than others, though. If you're in that camp, it could be that a fund you find appealing won't get a 4- or 5-star rating. Moreover, while it would be imprudent to use a highly risky fund as a large part of your portfolio, such a fund can work nicely if constitutes a small part of a well-constructed portfolio.
Looking through my own portfolio, for instance, I find Turner Midcap Growth (TMGFX). This racy number is offered as an option in Morningstar's own 401(k) plan. I keep it limited to a small portion of my account, carefully counterbalanced with value funds and larger stakes in less-volatile large caps. In 2003's massive rally, its 49.5% gain topped all the other funds I own in the 401(k). But its 2-star rating looks pretty woeful. It reflects the fact that the fund's heady risks were fully realized in the 2000-2002 bear market, and the fund's successes before then aren't reflected in the star rating because they were more than five but less than 10 years ago.
Clearly, this example demonstrates two deficiencies in the star rating. First and foremost, the three-, five-, and 10-year time periods often, but not always, reflect a fund's long-term success. We're always looking for ways to improve the star rating, and focusing on rolling-returns that better capture a fund's ups and downs might be a future improvement. Also, the star rating doesn't necessarily reflect your own personal asseessment of a sound risk/reward profile. It would be much more difficult to create a custom-fit star rating that would accurately reflect a given investor's risk tolerance. But you can find risky yet solid funds on your own, and it's not too difficult.
Today we'll use Premium Fund Screener to locate funds that have done well but have middling or low star ratings because of high risk scores. First, we'll ask to see distinct portfolios only, or one share-class per fund. We'll focus on domestic-stock funds (although performing this search on international funds yields intriguing results like Oppenheimer International Growth (OIGAX)). In the third line of the screen, we'll ask to see funds whose Morningstar Risk score is high, and in the fourth line, we'll ask for funds whose five-year trailing returns are in the top quartile of their respective categories. Next, we'll screen out any funds that overcame their high risk to get 4- or 5-star ratings. Finally, we'll decline to see any funds that are closed to new investors.
As of Dec. 16, 2004, this search yields 22 funds. To run the screen yourself, click here.
We'll look at three large-cap funds that pass our test.
Smith Barney Fundamental Value (SHFVX)
Manager John Goode is a true contrarian, diving into out-of-favor sectors in order to profit when they return to favor. Such an approach tends to lead to very choppy returns, for today's trash can be tomorrow's treasure. Witness the fund's nearly bottom-decile return in the large-blend category in 2002, largely the result of a bet on cyclical stocks in the industrial and hardware sectors. Those were the same stocks that drove the fund's killer returns in 2003 as the market rebounded. So the fund often looks and performs differently from its peers in the short run, but has been solid over the long term.
Neuberger Berman Focus (NBSSX)
This fund is even more volatile than Smith Barney Fundamental Value, but for very different reasons. While that fund is pretty diversified and swings from sector to sector, this one is very compact and generally sticks to a few favorite groups of stocks. It generally holds fewer than 30 stocks. Nearly 80% of its assets are invested in financial and hardware stocks, and it's been that way for some time. This year looks to mark the sixth straight calendar year that the fund's returns have finished in either the top or bottom quintile of the large-blend category. And yet, over the trailing five-, 10-, and 15-year periods, manager Kent Simons (joined by Bob Corman in 2003) has driven stellar returns.
Enterprise Equity (ENEAX)
This fund mirrors a much-better-known offering, TCW Galileo Select Equity (TGCEX). That zesty fund is managed by a team whose lead manager, Glen Bickerstaff, is stepping down at the end of 2004. Comanagers Craig Blum and Steve Burlingame will replace him, and we expect them to stick to the fund's strategy. This fund uses a buy-and-hold approach with a very compact portfolio--currently just 27 holdings. Top names include some of the best-known, fast-growing firms in the universe: Yahoo (YHOO), eBay (EBAY), Pixar (PIXR), and Starbucks (SBUX). While his fund's performance swings aren't as severe as the other two funds described here, a similar portfolio had a nearly bottom-quartile finish in 2002 when growth firms were severely punished.
Todd Trubey does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.