INVESTMENT INSIDER

Don Phillips on mutual funds

Morningstar's managing director has some advice on how you can make smarter investment choices.

When the stock market was humming, you could almost pick a winning fund blindfolded. No more. Only about 10 percent of domestic equity mutual funds' 12-month returns are in the black. And with the continuing market uncertainty, selecting funds carefully is more important than ever.

Many investors turn to Morningstar to help with their selections. The Chicago company, the leading provider of independent mutual fund and stock information, has more than 50 analysts who evaluate equities and mutual fund portfolios.

Morningstar's Star rating system, officially called the Risk-Adjusted Rating, has become an investing hallmark. The system assigns one to five stars to a mutual fund, based on how well the portfolio performed relative to the degree of risk taken.

Don Phillips, Morningstar's managing director, joined the company in 1986 as its first analyst. He soon became editor of the company's flagship publication, Morningstar Mutual Funds. Phillips helped develop the Morningstar style box, which categorizes mutual funds according to their holdings, and other proprietary innovations that are now industry standards.

Senior Editor Leslie Kane recently spoke with Phillips about the current state of mutual fund investing.

Looking at September's events and our current market uncertainty, should consumers have different investing criteria now?

Investors need to develop more realistic expectations. Many people counted on earning 20 to 30 percent annual returns from every mutual fund. Before the spring of 2000, it seemed to work, but the bubble has since burst. Although historical evidence suggests that stock prices will recover, the market isn't likely to reach those prior high growth rates.

I hope consumers now understand that over the long term—say, 10 or 15 years—few mutual funds will compound more than 15 percent annually, and most will return significantly less. Investors may have to save and invest more heavily, assuming lower returns to fund their goals.

Is there a common mistake that people frequently make when building a portfolio?

Some consumers perform the process in reverse—they choose specific investments before they've thought about what they're trying to accomplish. People debate what the Fed will do and whether the Dow will rise or fall, but they fail to evaluate their own relationship to money. They should ask themselves: What are my time horizons? What's my risk tolerance? When do I plan to retire? What tradeoffs am I willing to make between security and the chance of having a better lifestyle?

The answers to these questions determine the kinds of funds you should choose, how much volatility you can accept in your overall portfolio, what degree of risk you're willing to assume with each fund, and what proportions of bonds, equities, and cash you need. If you don't think about these things, you'll make investment decisions without a context. You may be tempted to invest in a risky fund in hopes of earning a 20 percent return, when you only need 8 percent—which requires much less risk—to achieve your goals.

How can investors do a better job of picking mutual funds?

Investors should bear in mind that mutual funds aren't static. Portfolio managers come and go; strategies change. Make sure a new manager's outlook is consistent with your goals for the fund. Read up about his philosophy and prior experience.

If a new manager repositions all the holdings, the fund's historical performance may not reflect his philosophy. So if a fund's 5-year average Star Rating is 5, but last year it earned a 3, look at the manager's tenure. If he started with the portfolio a year ago, you could be seeing the impact of his investing style.

Investors should also gauge a fund in relation to its peers. For example, in 1999, the 12-month return for large-cap growth funds averaged 41.4 percent. The Dodge & Cox Stock Fund, a large-cap value fund with a return of 7 percent for the year, clearly fell short in comparison. But that merely indicated the value fund category was out of favor, not that Dodge & Cox Stock Fund was below par. In fact, Dodge & Cox Stock's return put it in the top 20 percent of large-cap value funds, whose returns averaged only 6.9 percent in 1999.

How are the Star ratings calculated?

The ratings assume investors are reluctant to add risk without suitable compensation. To calculate each fund's Star rating for a certain time period—say, three years—we subtract its Morningstar Risk score, which is based on its monthly returns related to Treasury bills, from its Morningstar return score.

Next, we plot the results for all the funds on a bell curve. Funds that land in the top 10 percent of their broad asset class (domestic stock, international stock, taxable bond or municipal bond) receive five stars; those in the next 22.5 percent receive four stars; the middle 35 percent earn three stars; the next 22.5 percent receive two stars; and the bottom 10 percent get the lowest ranking, one star.

The current star rating of a fund is based on its 3-year, 5-year and 10-year weighted star average. The 10-year stats count for 50 percent of the overall score; the 5-year stats count for 30 percent, and the 3-year stats count for 20 percent. If there are less than 10-year figures available, other weights are used.  

How can investors make the best use of Star ratings? What are their downsides?

The Star rating system is a useful shortcut. It grades historical risk-adjusted performance and provides more information than raw performance data does.

The ratings identify all-weather funds that can be core holdings, and those likely to be volatile. However, this doesn't mean you should have only five-star funds in your portfolio. For instance, you might want a one-star precious metals fund for diversity, or because you believe in the sector.

As far as downsides, keep in mind that the rating system measures history; it doesn't predict the future. It also measures risk assuming that each fund is the only one an investor holds. But a fund's Star score may not reflect your overall risk if that fund is just one holding in a well-diversified portfolio. That's why even if you use the Star ratings, you should do your own research and make your own decisions.

What's your own investment strategy?

I'm contrarian. I identify great portfolio managers and invest a consistent amount in their funds monthly when their styles or sectors are out of favor, and when other asset classes are doing well. I buy funds when their prices are down. That way, I capture their best growth when they return to favor and their performance increases quickly. If you invest in a sector that's already hot, you've missed the biggest gains.

When a fund's style is back in vogue and its price has risen, I stop contributing. I generally keep my money in, but don't add more. I might sell shares in some of the best-performing funds, to help rebalance my portfolio.

What should investors be wary of in the next few years?

The mutual fund industry has an incredible sales machine. Investment companies can create funds to capture any popular sentiment. Internet funds, for example, tapped into the greed motive.

Now the zeitgeist might turn to fear. The industry could crank out funds that sell stocks short—counting on stock prices to fall—or use other concepts that sound appealing but essentially capitalize on current worries. Rather than get caught up in the mood of the moment, investors should evaluate any new funds based on their long-term goals and sound investment principles.

 

Leslie Kane. Investment Insider: Don Phillips on mutual funds. Medical Economics 2002;7:76.