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The Short Answer

Answering Your Unanswered Questions

Viewers of the recent Morningstar Individual Investor Conference wanted clarification on 5-star stocks, moat ratings, market cycles, and more. Here are the answers.

Morningstar recently held its annual online conference for individual investors and, as usual, viewers submitted loads of great questions, many of which we didn't have time to answer. For this week's Short Answer, we'll tackle some of these questions. And if you missed the conference, you can catch replays starting next week here at Morningstar.com. 

How often do you review the stocks on the recommended 5-star list? I noticed there are only 14 currently on the list.
The number of stocks that carry a 5-star rating can potentially change every day. The Morningstar Rating for stocks is calculated by comparing the market price for a stock at the end of the trading day with our analyst's fair value estimate of the security. A stock that is trading at a deep discount to its intrinsic worth would be rated 5 stars, with the size of the discount needed to reach that highest rating depending on our analyst's assessment of the uncertainty surrounding the fair value estimate. The star rating can change on any given day due to a move in price, an adjustment to a fair value estimate or uncertainty rating by the analyst, or a combination of both.
For more on how Morningstar analysts set fair value estimates and fair value uncertainty ratings, see this Short Answer

What is the difference between a wide moat and a narrow moat?
Morningstar assigns an economic moat rating based on the degree to which a company has sustainable competitive advantages. All of the nearly 1,500 companies covered by Morningstar's equity analysts receive a moat rating of wide, narrow, or no moat based on the degree to which these competitive advantages are present. (Sources of economic moat include intangible assets, switching costs, and network effect, as described in this document and this video.)

The distinction between companies with wide and narrow economic moats is one of duration rather than degree and is arguably less important than the distinction between those with moats and those without them. According to the methodology Morningstar uses to calculate moats (described in this paper), companies with wide moats are expected to earn excess returns on capital for at least 20 years, while those with narrow moats are expected to do so for at least 15 years. Or, to put it another way, a wide-moat company's sustainable competitive advantages are projected to last longer than those of a narrow-moat company.

It is easy to compare one mutual fund's performance against other mutual funds. How does one compare ETF performance against other ETFs in the same asset class?
Like traditional open-end mutual funds, exchange-traded funds are assigned categories based on their holdings. Those that hold primarily large-cap growth stocks are assigned to the large-growth category; those that hold primarily short-term bonds are assigned to the short-term bond category, and so on. And, as with mutual funds, each ETF page has a Performance tab that shows how the ETF stacks up against its ETF category peers on both a price and a net asset value, or NAV, basis. (For more on why an ETF's price and NAV may differ, click here.)

Can a person be too diversified? Or is it just more safe?
"Too diversified" is a matter of opinion, I'd say. But at a minimum, your portfolio should be diversified enough to match your tolerance for risk.

Remember that there are different types of diversification. There's diversification across asset classes--owning stocks, bonds, and real estate, for example--as well as diversification within an asset class--such as owning a variety of types of stocks rather than just a few types. In either case, the idea is to reduce the chances that poor performance in one part of your portfolio will sink the whole thing. So, for instance, if stocks are in a tailspin, the bonds in your portfolio are there to provide ballast. Likewise, if certain types of stocks are performing poorly, being diversified increases your chances of avoiding a full-blown portfolio meltdown. At the same time, being well diversified improves your odds of having at least one part of your portfolio performing well at all times. The idea is to spread out the risks in your portfolio rather than concentrating them in any one area.

Of course, the counterargument is that a concentrated portfolio offers investors the chance to outperform a well-diversified portfolio by focusing only on strong performers. However, anyone who lived through the tech bubble knows how badly that can turn out. So, yes, a diversified portfolio is more "safe" in a sense. It means giving up the opportunity to shoot out the lights when it comes to performance but can do wonders for your peace of mind.

Can someone define what a full market cycle is? 
While there's no set definition of what constitutes a full market cycle, the term is often used to refer to a length of time that includes both bull and bear markets. A bull market represents an environment in which an asset's price is increasing while a bear market, at least according to one widely used definition, represents a drop in price of at least 20% from the high price.

By studying how an investment performs across a full market cycle, investors can get a picture of how it might perform in different future environments. For example, an investor researching a mutual fund that he or she is considering as a long-term holding would be wise to consider its performance not only during the current bull market, which began six years ago, but in the bear market that preceded it as well. That way, he or she can get an indication as to whether the fund tends to perform well in some environments and worse in others.

Likewise, when analyzing a company's stock, it can be useful to look at its performance across a full market cycle to see how it has fared. So-called cyclical stocks tend to do much better when the economy is buzzing but not so well when it's in the dumps, whereas defensive stocks tend to perform more consistently across various economic climates.

Do mutual funds vote their shares?  Why or why not?  Do funds vote in their interests or in the interests of their customers? 
As holders of company stock, mutual funds are entitled to participate in proxy votes regarding how the company is run, including electing members to the company board and voting on pay for company executives. Mutual fund boards are supposed to vote on proxies involving the fund's holdings, although Laura Lutton, Morningstar's director of equity fund research, says that most delegate this responsibility to a committee within the fund company or to the fund's manager(s). She notes that boards for the American Funds and Putnam are exceptions to this rule and typically vote proxies themselves.

Funds are supposed to vote proxies in the best interest of the fund's shareholders and not necessarily of the fund or its parent company. But some critics, including Vanguard founder Jack Bogle, argue that mutual funds should be more active in terms of wielding their clout in proxy votes. They say that conflicts of interest--for instance, if a fund shop manages a company's retirement plan and also owns that company's stock in one of its funds--can get in the way.  

Funds are required to disclose their proxy votes to shareholders and must file a Form N-PX with the Securities and Exchange Commission by Aug. 31 of each year that covers all votes from the previous 12 months (you can search the EDGAR database for this form here). This information also is posted to the fund's website or available upon request.

Have a personal finance question you'd like answered? Send it to TheShortAnswer@morningstar.com.