'Five-star' funds are good bets, but no guarantee

MUTUAL FUNDS

November 01, 1992|By WERNER RENBERG | WERNER RENBERG,1992 By WERNER RENBERG

When a movie reviewer gives a four- or five-star rating to new film, you may decide to see it. When a food writer gives four or five stars to a restaurant that you've never patronized, you may decide to give it a try if its prices seem reasonable.

But what are you to think if an ad or promotional leaflet for a bond or equity mutual fund tells you that Morningstar Mutual Funds, a bi-weekly Chicago publication, has given the fund a five-star rating?

That an investment in the fund would make you a lot of money? That it would be very safe? Both?

Neither.

The five stars indicate that the fund has performed very well for several years, provided you take into account the degree of risk to which it subjected its shareholders. If it has involved high risk, for example, it should have had very high returns.

Can you rely on the five stars alone to tell you how well the fund will perform in the years ahead?

No. You know from experience -- or can assume -- that historical total return data don't guarantee how well a fund will perform in the future. You could say the same thing about data reflecting a fund's riskiness, which also are based on past performance.

Some fund sales people may want you to think that a five-star rating assures you of superior performance, but no one can give you such assurance. (Morningstar Inc., the publisher, used to assign "buy" recommendations to some of the five-star funds but stopped in July 1991 on grounds that the firm wanted to be considered a source of fund information, not advice.)

Morningstar's ratings reflect what's known as risk-adjusted performance, one of a fund's key characteristics. Expressed in one to five stars, they constitute a useful tool to help you to select funds.

They should be considered along with the treasure of other data contained in the publication and -- even more important -- the information in a fund's prospectus and latest shareholder report.

Risk-adjusted performance data have long been calculated for portfolios of securities to determine whether they adequately reward investors for taking risks, defined as volatility of monthly returns for three-year periods or longer. They've been used to analyze:

* Whether a fund's performance has been better or worse than you could have expected after comparing its volatility to that of returns for a benchmark such as the Standard & Poor's 500 Stock Price Index. The volatility comparison is expressed in a statistic called beta.

* Whether a fund's performance has been better or worse than you could have expected when factoring in its volatility, calculated by figuring how far a series of its monthly returns have deviated from their mean -- a step that generates what are called standard deviations.

When Joseph Mansueto founded Morningstar in 1984 as a fund data publishing company, he conceived a different technique for calculating risk-adjusted performance data for equity funds.

Risk levels would be based on how much investors could have lost over 10, 5, and 3 years in the months that a fund lagged no-risk Treasury bills. Returns for these periods would be adjusted for any loads and weighted. The two scores would be combined to produce the ratings and the top 10 percent would be given five stars.

He subsequently applied the methodology to three other fund classes -- municipal bond, taxable bond, and hybrid (balanced, asset allocation, income, convertible, and high-yield bond).

To see how the system has worked, let's look back five years. In Morningstar's October 23, 1987 issue, 46 equity funds and 10 fixed-income funds had the highest ratings.

In the October 30, 1992 issue, 11 of the 56 were among the 93 equity funds and 71 fixed income funds with five stars. (As ratings are updated regularly, some may have been bumped and restored.)

The 11 (see accompanying table), give you an idea of how the system cuts across fund types and risk levels. Four of the five bond funds are primarily invested in "junk" bonds while Vanguard's Short-Term Corporate Portfolio involves little credit or interest-rate risk.

Among equity funds, the growth funds run the range of investment styles from Fidelity Magellan to Sequoia, each of which, at last report, was about 75 percent in stocks. Under its new manager, Jeff Vinik, $21 billion Magellan had positions in more than 700 companies. William J. Ruane, who has managed the $1.3 billion Sequoia since 1970, was invested in a typically low number: 16.

For the last five years, total returns for the 11 compared well with the 9 percent annual return for the S&P 500. Naturally, they lagged a number of funds which, being riskier, rate fewer stars.

Of the remaining 45, 27 now have four stars (including Mutual Qualified Income, Mutual Shares, and SoGen International, each of which lost a star in the latest edition). Nine have three stars and eight have one or two stars. One fund has been merged into another.

As for returns, investors who bought and held most of the 45 funds for the five years had less reason for cheer. In fact, nearly half of the funds failed to match the 6 percent average annual return of T-bills, and a few even lost money. Five stars or not,

funds have to be screened for suitability -- and to be watched.

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