Beware: Some Top Mutual Funds Stink

I'm a checker of reviews and ratings. If I hear about a book or movie that sounds interesting, I'll look up more information on it before deciding to see or read it. If I need a new toilet, even though I may be impressed by American Standard's Champion model -- which can evacuate 29 golf balls in a single flush -- I'll still check to see which toilets Consumer Reports recommends. (Hey, if you're thinking of investing in the toilet giant, see what Rich Smith had to say about it recently.)

Thus, it's not surprising that on occasion, when I find myself at the Morningstar (Nasdaq: MORN  ) website looking up some esoteric information on a mutual fund, I find myself swayed by funds that have earned five-star ratings.

I recently ran across an interesting article, though, that has tempered my enthusiasm for five-star funds. Penned by Morningstar's own director of mutual fund research, Russel Kinnel, it candidly explained that because the quantitative nature of Morningstar's rating system invariably includes some duds on occasion, and "therefore does not serve as a substitute for fundamental research."

Crossed stars
Consider this scenario, for example. A fund invests heavily in some sector or nook, such as energy stocks or emerging markets. If that area has been on fire recently, the fund might have achieved amazing results in the recent past, making it look better in the eyes of the star-rating system. But hot areas inevitably cool off.

Similarly, a terrific fund might lose its top manager or managers. It won't show up in the ranking, but there are few changes more significant for a fund than the loss of its leadership.

As one example of an overrated fund, Kinnel pointed out the five-star Jacob Internet Fund (FUND: JAMFX  ) , saying:

This fund is a classic example of the quirkiness caused by the time periods that factor into the star rating. Investors who bought at inception are still about 70% in the hole, yet this fund still has five stars because its horrific bear-market losses are starting to roll off the five-year record. The fund's 79% loss in 2000 isn't there, and its 56% loss in 2001 is starting to fade.

Kinnel also cited its very high expense ratio (annual fee) of 2.64% and its "unimpressive manager."

In the fund's defense, I'll point out that its past few years of returns aren't so shabby: 101% in 2003, 32% in 2004, and 10.8% in 2005. Still, there are less risky ways to make money in mutual funds. (The fund's top holdings recently included Napster (Nasdaq: NAPS  ) , Sohu.com (Nasdaq: SOHU  ) , and Yahoo! (Nasdaq: YHOO  ) .)

Go beyond numbers
It's easy and tempting to find promising investments simply by running quantitative screens. Using Yahoo! Finance's stock screener, for example, I looked up S&P 500 component companies with profit margins of at least 20% and betas of no more than 1.0. That should give me stable, high-profit firms, right? Well, it will, but it will also include some stocks that might not be as attractive as I think. Moody's and Paychex (Nasdaq: PAYX  ) , for example, turned up, and although I think both are very strong, attractive companies, I don't think their stocks are the most attractive right now, because their prices have appreciated considerably recently. There are probably better bargains around.

The screen turned up UST, too. This one looks good in terms of various measures, but it deals in smokeless tobacco -- something that many investors might not want to invest in. And then there was Merck (NYSE: MRK  ) , far from a slam-dunk, with sizable debt and 2005 revenues below 2004 and 2003 levels.

Look at the big picture
So when you're prowling for stocks or funds, make sure you look at a lot of factors, not just a few. Focus on both the quality of the company (including profit margins, revenue and earnings growth, return on assets and equity, free cash flow, and competitive strengths) and on the stock's price (including the P/E ratio, market capitalization, and discounted cash flow analysis). Include qualitative factors as much as possible, too, such as the quality of management. With mutual funds, assess the long-term track record of the managers, as well as the fund's focus, its fees, and its communications to the public.

That's what Shannon Zimmerman does when he seeks out terrific funds with outstanding managers and reasonable fees, then recommends them for our Motley Fool Champion Funds newsletter. Try it for free to see which funds he has recommended -- and why. Together, his picks (as of the last time I checked) have more than doubled the market's return, gaining an average of 21% versus 10% in the same time period. Out of roughly 38 picks, not one was underwater!

Learn much more in these Zimmerman articles:

Longtime Fool contributor Selena Maranjian enhanced her home with doormats and curtains. She owns shares of no company mentioned in this article. For more about Selena, viewher bio andher profile. You might also be interested in these books she has written or co-written:The Motley Fool Money GuideandThe Motley Fool Investment Guide for Teens. Merck is a Motley Fool Income Investor pick. The Motley Fool isFools writing for Fools.


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