Frank James calls himself "the best money manager in Alpha, Ohio -- population 400." With $800 million in assets, mostly in private accounts, his company, James Investment Research, is small by investment industry standards, and he runs it from an isolated office on 35 wooded acres of countryside. "We're terrible at marketing here," he says. "We're not good at anything but research." Yet as a result of that research, one of James's three mutual funds -- the tiny $15.1 million James Small Cap Fund -- ranks in the top tier in BusinessWeek's Mutual Fund Scoreboard, having beaten the average stock fund's return over the past five years with far less downside risk. James's largest fund, the $92.1 million James Golden Rainbow Fund, which blends stocks and bonds, is a strong performer as well, just missing the top rating.
In both, James has been more concerned with risk control than with making big bets. "Investors who have done the best in the long run were those who focused on preserving capital in bad markets," he says.
BusinessWeek has been publishing the Mutual Fund Scoreboard for 20 years now, and it often unearths gems such as the James funds. The scoreboard's ratings are calculated by an objective, quantitative system wherein big marketing budgets or a portfolio manager's popularity don't count at all.
Of course, there's more here than the ratings. You can get all the basics, such as 1-, 3-, 5-, and, if available, 10-year returns; sales charges; and expense ratios. We also publish aftertax returns, a much harder-to-find number. Our calculations are based on each year's highest federal tax rates for dividends and capital gains. You get a truckload of portfolio data, too, including a fund's risk level, turnover, cash levels, and largest holdings.
HOMING IN ON GEMS
The heart of the scoreboard, though, is the ratings. To get one, a fund must be at least five years old. That's because in computing the grades, we first compare each fund's monthly performance with three-month U.S. Treasury bills in each of the past 60 months. When a fund fails to beat the T-bill's "risk-free" return, it gets negative marks, which are then subtracted from its nominal total return. Next we rerank all of the equity funds on these risk-adjusted results. Of 2,612 equity funds with five-year track records, only 195 earned an "A" this year. Tables of all of our A-rated stock funds start on page 88, but you can find an interactive version of the entire scoreboard at bwnt.businessweek.com/mutual_fund/.Next week we'll look at bond funds.
We also rate funds against others in specific categories, such as large-cap growth, foreign, or real estate funds. Only 180 made an A category grade in the latest scoreboard. A category rating serves two purposes. It's a good way to identify the best funds in out-of-favor sectors -- funds that wouldn't do well in the overall ratings. And it indicates the best plays in a sector so strong that all the funds seem to be shining. For instance, 63 small-cap value funds now receive A grades for overall performance, in part because over the past five years small-cap stocks have soundly beaten large-cap, and value stocks trounced growth. But look at the category rating, and you'll find that only 9 of those 63 got As, and only three are open to new investors -- American AAdvantage Small Cap Value (AVPAX ), Pacific Capital Small Cap, and CGM Focus (CGMFX ). All told, only 53 funds got A ratings for both their category and overall performance.
Real estate has been even hotter than small-caps in recent years, with 49 such funds receiving overall A ratings. That's up from just 18 a year ago. Drill down into the category grades of such funds, and you'll find not nearly as many are appealing. Only three -- Alpine Realty Income & Growth (AIGYX ), Alpine U.S. Real Estate Equity (EUEYX ), and CGM Realty -- receive double-A ratings.
Alpine Funds President Sam Lieber would be the first to warn that you may be buying near a peak. Real estate investment trusts (REITS), publicly traded companies that buy real estate, are on average "trading at a 15% to 20% premium to the values of their underlying properties, which are richly priced as well," he says.
Since Lieber must invest in real estate, he pays close attention to risk control. Alpine Realty Income & Growth invests heavily in REIT preferred stocks, which are higher-yielding and less volatile than REIT common shares. Lieber is also not afraid to take profits and increase cash positions as valuations rise. Our scoreboard lists his cash positions. In general it's a good indicator of how enthusiastic a manager is about his investment sector: the more cash, the less excitement. Bear in mind that the portfolio data reflect the most recently published fund reports, and cash levels can change quickly.
That said, the scoreboard's portfolio data can give you a lot of insight into a fund. For instance, Hibernia Mid Cap Equity has low turnover. That sets it apart from most mid-cap growth funds, which tend to have rapid-fire trading practices. Martin Sirera, the fund's manager, believes his buy-and-hold philosophy contributes to the fund's success. "A low turnover adds to performance over the long run because it keeps transaction and market-impact costs down," he says. Of the nine mid-cap growth funds that earned A category ratings, eight have low or very low rates of share turnover.
Another telling scoreboard statistic is the percentage of the fund made up by the 10 largest stocks. For the ABN AMRO (CHTTX ) Mid Cap Fund, for instance, the figure is 39%. Since the average fund has about 22.4% in its top 10, this ABN AMRO mid-cap fund is fairly concentrated. The higher this number, the more dependent the fund is on the performance of individual stocks rather than broader market trends. Concentration can be risky, but this fund's risk rating is average. That's because manager Thyra Zerhusen mitigates downside risk by making it her business to know the companies she owns "in depth" and invests only in those with clean balance sheets and defensible product lines such as Readers Digest Assn. and Engelhard Corp., a specialty-chemical maker. "I wouldn't buy a retailer like Gap, which could do great this year but badly in the next because fashions have changed," she says.
GOOD FUNDS, BAD SECTORS
Another important scoreboard stat is a fund's worst quarter in the past five years. Consider it a stress test, enabling you to visualize a fund's potential losses in the depths of a bear market. Looking at the A-rated Berwyn Income Fund (BERIX ), we can see that the 2.4% loss in the second quarter of 2004 is small relative to most of the other funds on the A list. Its 7.3% best quarter in 2003 is equally small. By contrast the Lou Holland Growth Fund is more volatile, with a 15.8% loss during its worst quarter in 2002. But it has also had a higher high, gaining 15.7% during its best quarter in 2001. For a fund in the long-suffering large-cap growth category, it has managed to navigate the past five years well enough for an A category rating, though it has a C overall. Buying good funds in unpopular categories can be a smart investment strategy.
Technology funds have suffered the most of any category in recent years, so any of those funds that pops up on the A list is of interest. Only four score an A category rating: Fidelity Select Software & Computer Services Portfolio (FSCSX ), Icon Information Technology, North Track PSE Tech 100 Index, and Franklin DynaTech. None has an overall rating better than C. Franklin DynaTech is new to the list, though its lead manager, Rupert Johnson Jr., has 36 years of experience as a technology fund manager. "Our strategy is a little different," says co-manager Robert Dean. "Instead of being a pure tech fund, it's an innovation-type fund, heavily weighted in technology but also health care and other industries." That diversification, plus Johnson and Dean's decision to move heavily into cash when the downturn started, helped cushion the blow of the bear market. The fund has still managed to deliver solid, albeit not stellar, returns during the bull market.
In general it is better to invest in A-rated funds that are broadly diversified. In that light there's hardly a more diversified fund than Oakmark Global (OAKGX ). "I have the best job in the world because my investment mandate is so broad," says Michael Welsh, the fund's manager. "I'm not limited by geography or market cap."
Welsh takes full advantage of his flexibility. After years of investing in cheap, tiny small-cap foreign stocks he has the freedom to move into blue chips, such as food giant Nestlé (NSRGY ) and drugmaker GlaxoSmithKline (GSK ), which he says offer more attractive valuations. Of course, such flexibility also means that a manager has more chances to screw up by picking the wrong country or stock group. All the more reason to own an A-rated fund.
By Lewis Braham