No Ratings Downgrades for November
Nevertheless, it was a busy month for Morningstar Analyst Ratings.
Morningstar manager research analysts were busy in November, taking well over 200 U.S.-domiciled funds through the team's North American and global ratings committees. In total, we reaffirmed our views on 125 funds, upgraded 10 funds, and put seven funds under review. It was an unusual month in that no fund saw a downgrade in its rating, though three of the 61 funds newly brought under coverage received inaugural Morningstar Analyst Ratings of Negative. Below, we highlight some of the more noteworthy changes, and a table at the end summarizes all of the rating changes and additions.
We cover over 1,700 mutual funds and exchange-traded funds sold in the United States, and of those, less than 10% receive Analyst Ratings of Gold. It's notable, then, that we upgraded two funds to Gold last month. Both were from Vermont-based Champlain Investment Partners: Champlain Small Company (CIPSX) and Champlain Mid Cap (CIPMX).
Portfolio manager, CIO, and firm co-founder Scott Brayman leads the charge at both funds, which were launched in 2004 and 2008, respectively. Despite the retirement of two longtime members in late 2016, Brayman's supporting team is strong, averaging more than 15 years' industry experience. For both funds, the tenured team singles out companies that feature superior relative growth, high returns on equity, low debt, strong and predictable earnings, capable management, and stable business models.
The team's valuation focus and quality bias can hold the funds back in more speculative bull markets, but largely by holding up well in market downturns, both funds outpaced their small-growth and mid-cap growth peers since their respective inceptions through the end of November 2017. Champlain Small Company has been closed to new investors since 2007, and Champlain Mid Cap closed to new investors in October 2017.
We put funds under review whenever a change occurs that we believe could affect a fund's Analyst Rating or any of the five pillar scores that underlie the rating. For example, we put both of the Highland funds that we have under coverage-- Highland Global Allocation (HCOAX) and Highland Long/Short Equity (HEOZX)--under review following potentially adverse developments at Highland Capital Management.
At the end of November, a Texas arbitration panel resolved a dispute between a former Highland Capital portfolio manager and the firm's management, according to media reports. The litigation and the panel's reported findings raise questions about Highland's corporate culture and stewardship of client capital. As such, we put the Highland Funds' Parent Pillar rating under review. Highland Funds' previous Parent rating was Neutral. After we have re-evaluated Highland's Parent rating, we will update the funds' Analyst Ratings.
We strive to quickly update our ratings after we put them under review, and so far, three funds have come out of that status in early December. Fidelity GNMA (FGMNX) and Fidelity Mortgage Securities (FMSFX) emerged from under review with their respective Gold and Silver ratings intact. Although the departure of long-term manager Bill Irving from those funds is notable, he leaves behind a strong team, and both funds continue to have thoughtful investment strategies and reasonable fees.
We ultimately downgraded Fidelity Government Income (FGOVX) in early December after putting it under review in November. This fund also benefits from the strong team left following Irving's departure. However, a history of lagging its benchmark, combined with an eroding expense edge that makes it more difficult for this Treasury-heavy portfolio to beat competitors, dulls its appeal somewhat. As a result, we downgraded its Analyst Rating to Bronze from Gold.
The slate of newly rated funds included three Negative ratings; each of these funds faces hurdles that make them likely to fall behind their peers and relevant indexes over the long term. Both SkyBridge Dividend Value (SKYIX) and Clough China (CHNIX) face high costs, for example, that hold the funds back from the start. SkyBridge has also shown cracks in its rules-based strategy, as its valuation and yield screens can lead to names with iffy fundamentals or potentially unsustainable dividends. Clough China, in contrast, has an investment approach that results in a benchmarklike portfolio with high turnover, contributing to a Negative Process rating. Inconsistent with the team's stated long-term investment horizon, portfolio turnover is extreme, raising total costs for investors. Turnover has averaged 158% during the past five calendar years, well above the China region Morningstar Category average of 81%.
Deutsche CROCI International (SCINX) also earns its Negative rating largely because of its Negative Process rating. This fund uses an analyst team to methodically convert companies' financial statements from different sectors and countries into comparable measurements, which the team uses to calculate what it calls a stock's real economic P/E ratio. The managers invest equally in the 50 non-U.S. stocks with the lowest economic P/E ratios. The fund's process, however, is risky and unsettled. It uses only trailing data, and it lacks adequate safety checks that might prevent it from falling into large value traps. It has also gone through process changes in recent years, and management expects to go through a few more. For any of these Negative-rated funds, we believe investors can find better options elsewhere.
Morningstar analysts Chris Franz, Tayfun Icten, Sarah Bush, Andrew Daniels, and George Georgiev contributed to this article.
Janet Yang Rohr, CFA does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.