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Look for the real fund stars

Star worship has no place in mutual fund investing.

Sure, you might want to look at the star rating for a fund before you buy it. We all like trivia, don't we? But making buy/sell decisions based on star ratings is just dumb.

This point is raised for two reasons, one of them being some communications to this column from investors perturbed over the fact that the star ratings for their fund had recently fallen. A reason to sell? Negative. You'd no more dump a fund that had lost a star than you'd stop being a Toronto Maple Leaf fan because the team slumps every now and again. Okay, bad example. But you get the idea.

Another reason to go easy on those star ratings is that there's much better fodder out there for mutual fund investors looking for more than numbers and charts. Just go to the Morningstar Canada website ( and check out the list of fund analyst picks.

Morningstar is an independent fund research firm with a staff of six analysts who slice and dice funds and then issue reports that you can read at no cost on the firm's website. The funds that really impress go onto the list of fund analyst picks, which means they're well worth a look if you're in the hunt for funds to buy.

Now, it's true that Morningstar pretty much wrote the book on star ratings for mutual funds. A five-star rating from the firm is much coveted and it's not unusual to see fund companies playing up this distinction when they earn it.

But Morningstar's star system suffers from the same problem as all such rating efforts. In effect, they're little more than rear-view mirrors telling you about past behaviour and nothing about the inner workings of a fund and how they might play out in the future.

One of the appealing things about the Morningstar fund analyst picks is that they have nothing to do with the company's star system. Whereas the stars are assigned by a computer program that analyzes risk and return data, the analyst picks have to meet stringent criteria in several different areas.

Here's David O'Leary, manager of fund analysis at Morningstar, on how fund analyst picks are judged:

Returns: "We want managers who produce strong returns over the long haul, not just over a three- or five-year period," he said.

Downside performance: "In a rising market, it's very hard to distinguish luck from skill. It's when you go through the tough times that management skill comes out."

Fees: "The lower the better."

Consistency of the investing strategy in use: "If there are periods of underperformance, we're fine with that as long over the long haul the strategy has proven to work out."

One other factor that goes into the analysis is called stewardship and it refers to the corporate culture of the company offering a particular fund. Investor-friendly policies are emphasized here, with an example being a record of trimming fees on a fund as its assets grow.

Morningstar's analyst pick list was made public at the end of October and now includes some 66 names drawn from more than 350 funds that have been written up in a full report that you can read online. "A fund has to be nominated by the analyst who covers it," Mr. O'Leary said. "The analyst basically has put together a case for why they believe it should be a pick."

Fund companies have already sized up the analyst fund picks as something to be exploited for marketing purposes. Last week, Saxon Financial Inc. issued a press release to announce that three of its funds have made the list. It's worth noting here that Morningstar analysts have complete independence in compiling the list of favourites and they're not afraid to take a contrarian view.

You can see this in the four or so analyst favourites that coincidentally have a one- or two-star Morningstar rating. Examples include Saxon World Growth, managed by Robert Tattersall; CI Value Trust Corporate Class, managed by Bill Miller; and, CIBC Canadian Equity Value, managed by Gaelen Morphet.

Another example is Phillips Hager & North Global Equity, a long-time dud that was recently handed over to new managers, Jennifer Witterick and Carl Lytollis, who so far have not distinguished themselves. Mr. O'Leary said the fund made the favourites list because of the long-term track record of the new managers. "Both of them have built fantastic records on the institutional side. We're pretty confident they can translate that into success on the retail side."

This is the kind of insider stuff that makes the list of Morningstar analyst picks such a useful database for people who want help choosing mutual funds. Star-struck fund investors should definitely check them out.


Buy low opportunities?

The independent mutual fund research firm Morningstar Canada has assembled a list of funds its analysts think highly of. Here are some that have coincidentally received one- or two-star ratings from Morningstar, which indicates that returns have been disappointing.

FundThree-year return*
Brandes Emerging Markets+19.2%
Brandes Global Small Capitalization- 1.5%
CI Value Trust Corporate Class- 0.5%
CIBC Canadian Equity Value+11.1%
Mackenzie Cundill Canadian Security+8.0%
PH&N Global Equity+2.9%
PH&N Overseas Equity+9.5%
PH&N US Equity- 1.0%
Saxon World Growth+3.5%
Trimark Global High Yield+1.4%

*annualized return to Oct. 31

© 2007 The Globe and Mail. All rights reserved.

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