With the bull stumbling after a five-year stampede, investors are learning that mutual-fund statements don't always bring good news. Indeed, with the average equity fund up a scant 2.3% in this year's first half, even patient, long-term sorts may lack the resources--or sense of humor--to tolerate laggards.
But don't dump a lumbering large-cap value fund for a rocketing small-cap growth portfolio without considering the risks those funds take with your money. If you've only measured total returns, you're not seeing the entire picture. Adjusted for risk, that highflier's appeal might dim, and the slow mover just might be a keeper.
Whether you are looking to make sweeping or minor changes to your portfolio, BUSINESS WEEK's Mutual Fund Scoreboard can help. We've rated funds in the magazine every January for 15 years, and for the past 30 months, we've been doing it monthly online at our Web site (www.businessweek.com/mutualfunds/mutfunds/scorebrd/index.html).
We rate funds two ways. The overall rating compares each equity fund to all equity funds. The category ratings compare funds with similar investment styles. In grading bond funds, we rate taxable funds and tax-exempt funds separately, and we rate them in such categories as high yield and long-term government. The ratings are calculated by Morningstar.
WHAT RISK? The online Scoreboard goes well beyond ratings. It carries performance data for the past month and for three months; for the year-to-date period; and for the past 1-, 3-, 5-, and 10-year periods. There are data on fund risk and portfolio turnover, and don't forget sales charges and expenses. The Scoreboard is interactive as well: You can screen for funds by categories, ratings, returns, or the fund's name.
The Scoreboard and ratings system extend to bond funds (table, page 122). In the rip-roaring equity market of recent years, bond funds have been all but ignored. After the wild ride equity investors have had since March, the relative calm of bond funds may be more appealing.
With more than 4,800 funds in its database, the Scoreboard includes not only such big, well-known names as Fidelity Magellan but also hundreds of undiscovered ones. In fact, several well-kept secrets, such as $50.9 million Buffalo USA Global Fund and $98 million Meridian Value Fund, are among the 42 new names that have reached the A-list so far this year (table) and merit your consideration.
Such pint-size funds have an important edge in today's market: Because they have fewer dollars under management than more bloated rivals, they can move in and out of stocks more easily--and often without influencing prices. "Being small is somewhat of an advantage," says John Calamos, whose Calamos Market Neutral fund is among the new stars.
BUSINESS WEEK's top performers cover a range of investment styles that can fill almost any gap in a portfolio. Need a large-cap value fund to replace one you unloaded when value stocks were punished over the past two years? There are seven new top-rated ones to choose from, including Gabelli Westwood Equity and Selected American Shares. If you want international exposure, check out Tweedy Browne Global Value or one of the four other world funds new to the list. Investors frightened by the market's wild swings might gravitate instead toward a domestic hybrid fund that blends stocks, bonds, and cash. A growing number of these low-risk offerings--which often have "balanced" or "asset allocation" in their names--now receive BUSINESS WEEK's highest grade of A.
To rate mutual funds, BUSINESS WEEK measures performance over a five-year horizon. Many other systems stop there. We go a step further by adjusting the data to reflect risk and then reranking the funds. The top 7.5% of them get an A, the grade for superior risk-adjusted returns. The next 12.5% get B+, still an admirable rating. Then the next 17.5% of the funds earn a B, and the next 25% get a C for average. On the way down, 17.5% get C-, 12.5% D, and the bottom 7.5% get an F.
In addition to the risk-adjusted ratings, the Scoreboard also categorizes the funds' level of risk--very high, high, average, low, and very low. The risk profile is important: While academics and Wall Street analysts find it virtually impossible to predict an investment's future performance, studies show that risk levels tend to be far less variable and thus more predictable.
That's not to say that A-rated funds are a sure thing. In fact, about a third of the A-list has turned over since January. But because BUSINESS WEEK only rates funds with five-year performance records, it's rare that a star fund will fall far. Indeed, many funds demoted since January have landed in the B+ category. That's what happened to the Standard & Poor's 500-stock index funds that populated the A-list last year.
The A-team is so selective that most high-flying Internet and technology funds don't make the grade. That's because even those old enough to have five-year track records--no Net-only fund has yet reached that point--fall short when their performance is adjusted for risk.
Still, the newcomers include one tech fund. It's the $3.3 billion Firsthand Technology Value fund, which has posted an average annual return of 58.3% for the five-year period ending June 30. Keep in mind that Firsthand falls in the "very high" risk category. Still, the fund's average annual return is 10% a year better than the next-best of the funds in the highest risk bracket.
At the opposite end of the risk spectrum is another newcomer to the A-list. The tiny, $35 million Calamos Market Neutral fund has a five-year annualized record of 12.1%. It makes the cut because its low risk level makes losses rare. "A market-neutral posture means the fund should have a relatively good return, whether the equity markets go up or down," Calamos explains. Indeed, the 10-year-old fund--which buys a company's convertible bonds while selling its stock short--has posted fairly steady returns of 8% to 14% per year. In part that's because of the cushion provided by the interest on its convertible bond portfolio. To be sure, such funds lag when stocks soar. But they do well when volatility rises, as it has this year. Over the past 12 months, Market Neutral is up 17.9%.
VALUE LIVES. Value funds can also offer protection in choppy markets. Although the value style of investing in beaten-down stocks has trailed its growth counterpart badly in recent years, such stocks have shown signs of life since January. Reflecting that, seven large-cap value funds have joined the A-list this year.
The smallest is the $200 million Gabelli Westwood Equity fund. Portfolio manager Susan Byrne looks for companies that can grow faster than expected. But to limit risk, she won't pay a lot for their shares. One pick is natural-gas exploration and production company Apache, which Byrne figures is already a bargain at five times Wall Street's forecast of $10.40 per share in cash flow for this year. If Apache surprises investors by hitting Byrne's $11.50 target, the stock should do well. Even if the company falls short, she figures, the stock is cheap enough that it won't get killed.
Byrne takes other steps to insulate her 40-stock portfolio from risk. She owns several dividend-paying real estate investment trusts (REITs) and electric utilities. And she focuses on companies that she believes sell for a discount to their growth rates. Byrne puts IBM, Hewlett-Packard, and Compaq in that camp.
Good, undiscovered funds aren't necessarily confined to out-of-favor sectors. At $25 million in assets, the Eastcliff Total Return fund is minuscule compared with most large-cap growth portfolios, which have soared in recent years. But with an average annual five-year return of 25.8%, it beats the S&P by two percentage points and outpaces many household names, including Fidelity Magellan.
When shopping for stocks, portfolio manager Patti Neverett starts with sectors that are likely to benefit from broad economic trends. Current favorites include telecommunications and technology, which together claim more than 60% of the fund's assets. She likes market leaders, such as EMC, Microsoft, and Cisco Systems, and looks for earnings and revenue growth of 20% or more.
When a stock falls, Neverett will bail out if a company's fundamentals have deteriorated. Otherwise, she'll sit tight, as she is doing with Microsoft. "I'm a buy-and-hold investor," she says.
Another undiscovered fund in a top-performing sector is the $50.9 billion Buffalo USA Global fund. Co-managers Tom Laming and Bill Kornitzer look for U.S.-based companies that generate at least 40% of their sales or earnings overseas and have good long-term growth prospects. Then, they use a discounted cash-flow analysis to find stocks that can rise at least 35%. Once a stock reaches what they believe is its true value, the managers sell. One recent example is Applied Micro Circuits. "We've done pretty well with technology this year compared with an average tech fund because we look at what a stock is actually worth," Laming says.
Don't overlook bond funds. In the first half of the year, they have surpassed their equity counterparts, rising 3.02% on average, vs. 2.3% for stock funds. The list of A-rated bond funds includes numerous municipal portfolios, where interest income is tax-free. A few short-term funds also make the cut--not surprising since they were able to move quickly to take advantage of rate hikes earlier this year.
History shows that over long periods, equities beat bonds. But not all equity funds do the job equally well. By identifying those funds that deliver the most reward for the least risk, the BUSINESS WEEK Mutual Fund Scoreboard can help you make the most of your investments.