Look Beyond the Stars

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Look Beyond the Stars
by Michael Iachini, CFA, CFP®, Director, Investment Manager Research, Schwab Center for Financial Research
July 31, 2007

Reprinted from the July 2007 issue of Schwab Investing Insights®, a monthly publication for Schwab clients.

Looking for a great mutual fund? If you're like many investors, you may just look for a fund with a five-star Morningstar rating and call it a day. After all, the fund has been a top performer. What more could you want?

How about a fund that will perform well in the future?

In the words of one Morningstar analyst, "The star rating is not meant as a way to predict which funds will do well going forward."¹ If a fund has invested heavily in a hot sector or a style that has been in favor, it will likely have a high Morningstar rating. But will that same style keep on working forever? Not necessarily! Just ask investors who loaded up on technology stocks in 1999.

Smart investors look beyond the stars to understand what makes a fund tick, how it earned its strong record and what its future prospects are. Remember, you're not buying funds in a vacuum. So whatever steroids fund managers use to enhance their current performance may take a toll on your portfolio over the long term.

Inside the stars: how the ratings work
The Morningstar rating is a risk-adjusted return measure—the higher a fund's returns and the lower its risk relative to its peer group, the higher the star rating. Morningstar calculates star ratings based on three, five and 10 years of performance (with the most weight given to the three-year period). The adjustment for risk means that a fund whose returns have been quite volatile will have a lower rating than a fund with the same result but fewer ups and downs (for details, see the sidebar, "The Nitty-Gritty of Star Ratings"). And since funds are rated relative to their Morningstar category peers, you should have an apples-to-apples comparison (small value vs. small value, etc.).

Blinded by the starlight: what star ratings can mask
So what could be wrong with a five-star fund? It may be tilted toward what worked yesterday, not tomorrow. Here are some examples:

Size bets. Small-cap stocks have outperformed large-cap stocks for seven of the past eight calendar years through 2006.²Morningstar ratings do not adjust for this effect. This means that funds that shifted toward smaller companies over this period currently tend to receive higher ratings. For instance, the large-growth SM&R Alger Aggressive Growth B (SRABX) earned five stars for its strong returns. But the average stock in this fund has a market capitalization of only $9.6 billion, less than one-third of the large-growth category average of $34 billion. Eschewing its chosen style for smaller companies has paid off in the past, but if small-cap performance drops and the fund does not alter its strategy, this fund may suffer vis-à-vis its peers.
Style bets. Similarly, value stocks have outperformed growth stocks for seven of the past eight years.³ This has led to a situation in which five-star funds now tend to be value-tilted. For instance, the typical five-star large-growth fund now has a lower-than-average price-to-book ratio (a comparison of the market price of a company to the value of its tangible assets and one common way to distinguish value from growth stocks). Take the five-star AIM Multi-Sector (IAMSX), with a price-to-book ratio of 2.8—much lower than the average 3.9 ratio for large-growth funds, betraying a heavier value orientation than its peers. If growth stocks come back into favor, such funds may face an uphill battle relative to their peers.
Sector bets. From time to time, certain market sectors outperform others, as tech stocks did in the late 1990s. It's great to be tilted toward a particular sector as long as it's doing well. But the problem is that it's hard to predict when times are going to change—again, as with the bursting of the tech bubble.

Large-Growth Funds Can Earn Stars by Tactical Tilts
	Average large-growth fund	Average five-star large-growth fund	Performance-boosting tilts
Company size	$33.8 billion	$25.9 billion	Smaller-cap stocks
Price-to-book ratio	3.9	3.5	Value stocks
% foreign stocks	7.6%	18.8%	Global equities
% energy stocks	5.8%	9.0%	Sector bets
Data from Morningstar as of May 31, 2007.

Because energy has been the big winner recently, many five-star funds achieved their results with large energy allocations. For the five years ending in 2006, the S&P 500® energy sector returned a cumulative 116%, compared to 24% for the S&P 500 index as a whole. The average large-growth fund has less than 6% of its portfolio in energy stocks, but the average five-star large-growth fund has nearly 9% in the sector. The difference is even bigger for mid-cap blend funds, where about 7% of typical fund assets are in energy, compared to over 14% for five-star funds. One example of a sector-focused five-star fund is John Hancock Large Cap Equity I (JLVIX), with nearly 35% of its portfolio in energy stocks. Before buying a fund, make sure you look at its sector bets.

International bets. Foreign stocks have outperformed U.S. stocks for the past five years, so domestic funds that invest in foreign stocks have tended to move up in the rankings.⁴The typical five-star large-growth fund, for instance, holds 19% of its assets in foreign stocks. The five-star American Funds New Economy R1 (RNGAX) holds more than 37% of its assets in non-U.S. stocks. If you're buying a fund for its U.S. exposure, check what's inside.
Regional bets. In recent years, emerging-market stocks have performed particularly well. During the five years ending in 2006, the MSCI Emerging Markets Index returned an annualized 26.59%, compared to 14.98% for the MSCI EAFE® Index. The average international fund has roughly 13% of its portfolio in emerging-market stocks, but the average five-star international fund has over 17% in emerging markets. For instance, the five-star Allianz NFJ International Value Institutional (ANJIX), a foreign large-value fund, holds over 30% of assets in emerging-market stocks.

Indeed, emerging-market economies may deserve a place in your portfolio, and we encourage investors to consider putting a small piece of their international assets into emerging markets. But if you already have emerging-market funds in your portfolio, be sure you're not overexposed through your other international funds.

Why do these bets matter?
So why should you care if your manager has these bets in place? Shouldn't good managers be willing to bet where they're confident the market will go? It's true that some managers may seek to profit by timing the market or following a strategy of rotating among sectors or regions—and if a fund manager can swiftly adapt to changing market conditions, that's a skill that should be rewarded.

However, many managers tend to stay in certain parts of the market for long periods and not leave those areas when conditions change. A manager who leans toward value stocks may tend to favor them whether they're in vogue or not—the manager often has such a tilt as a side effect of his or her management process. Generally, these managers aren't likely to move when the market moves against them. They may have earned five stars by being in the right place in the past—but that doesn't mean it's the right place now.

Beyond the stars: what you can do
A highly rated fund may be a good place to start your research, but there are other factors to consider. When you research a fund on Schwab.com/funds, click through to the Portfolio tab and check the fund's allocation for anything that seems unusual, such as a high percentage of assets in foreign stock for a domestic fund.

At Schwab, we think that when you buy a large-growth fund for your portfolio, it should stay one. No matter how well it does by bringing in small-cap bets, if it doesn't give you consistent large-growth exposure, we believe it's failing you. What's more, sector, size and style effects can be highly unpredictable, but good security-selection skill tends to persist. When we evaluate a fund's past performance, we adjust for risk exposure, as well as style, cap and sector bets.

Our favorite funds are true to their category and exhibit superior stock selection over time. We also look for low expenses, high fund-family assets, the right level of fund assets and reasonable cash flows. And we subject funds to tough qualitative scrutiny. Is the fund manager who earned the strong record still at the helm? Does the fund have good risk controls? Is it disciplined?

The good news is that we've brought together all of these considerations in the Schwab Mutual Fund OneSource Select List®. We believe that these funds have the right combination of solid past performance, strong quantitative characteristics and high-quality management to potentially deliver good returns tomorrow and beyond. If you're a Schwab client, log in to Schwab.com/selectlist to start your own research.

True to Form: High-Star Schwab Mutual Fund OneSource Select List Funds That Stick to Their Categories
Ticker	Name	Category	Gross expense ratio	Net expense ratio
AAGPX	American Beacon Large Cap Value Plan	Large value	0.87%	0.87%
BGRFX	Baron Growth	Small growth	1.31%	1.31%
SSAIX	SSgA International Stock Selection	Foreign large blend	1.20%	1.00%
SWANX	Schwab Core Equity	Large blend	0.81%	0.75%
TEQUX	Transamerica Premier Equity Inv	Large growth	1.15%	1.15%
Data from Morningstar as of May 31, 2007.

The Nitty-Gritty of Star Ratings

Prior to 2002, Morningstar's star ratings compared all domestic equity funds against one another, which often led to situations in which funds of a certain style (say, small value) earned four or five stars just because that style had been in favor. The current star rating methodology rates each fund only against its category peers, mitigating the problem, though considerable variation may still exist among funds in a category.

The technical details of the star rating calculation are extensive, but the main point to understand is that funds are ranked against their category peers based on Morningstar's risk-adjusted returns for three-, five- and 10-year periods. These returns are adjusted for volatility to provide an understanding of how much risk a fund takes on to earn its returns.

Once the funds in a category have been ranked by risk-adjusted returns, the top 10% of funds receive five stars, the next 22.5% receive four stars, the next 35% receive three stars, the next 22.5% receive two stars and the bottom 10% receive one star. The ratings for the three-, five- and 10-year periods are averaged to arrive at an Overall Morningstar Rating™, with 20% weight given to the three-year rating, 30% to the five-year rating and 50% to the 10-year rating. The most recent three-year period, despite the low weight given to the three-year rating, actually has the greatest impact on the fund's overall rating because it is included in all three rating periods.

1. David Kathman, "

," Morningstar, October 17, 2006.
2. Small-cap stocks represented by the Russell 2000® Index, large-cap stocks by the S&P 500 index.
3. Value stocks represented by the Russell 1000® Value Index, growth stocks by the Russell 1000 Growth Index.
4. Foreign stocks represented by the MSCI EAFE Index net of taxes, U.S. stocks by the S&P 500 index.

Important Disclosures

Investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing. Investment value and return will fluctuate such that shares, when redeemed, may be worth more or less than original cost.

Morningstar gives its best ratings of five or four stars to the top 32.5% of all funds (of the 32.5%, 10% get five stars and 22.5% get four stars) based on their risk-adjusted returns. For each fund with at least a three-year history, Morningstar calculates a Morningstar Rating™ based on a Morningstar Risk-Adjusted Return measure that accounts for variation in a fund's monthly performance (including the effects of sales charges, loads and redemption fees), placing more emphasis on downward variations and rewarding consistent performance. (Each share class is counted as a fraction of one fund within this scale and rated separately, which may cause slight variations in the distribution percentages.)

Approximately 2,100 funds participate in the Mutual Fund OneSource® service. Only these funds, including Schwab Affiliate Funds, are eligible for the Mutual Fund OneSource Select List. Schwab receives remuneration from fund companies, and/or their affiliates, in the Mutual Fund OneSource service for recordkeeping, shareholder services and other administrative services.

The S&P 500 is an index of widely traded stocks. Indexes are unmanaged, do not incur fees or expenses and cannot be invested in directly.

The MSCI EAFE® Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure developed market equity performance, excluding the United States and Canada. As of May 2005, the MSCI EAFE Index consisted of the following 21 developed market country indexes: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the United Kingdom.

The MSCI Emerging Markets Index^SM is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets. As of May 2005, the MSCI Emerging Markets Index consisted of the following 26 emerging market country indexes: Argentina, Brazil, Chile, China, Colombia, the Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Jordan, Korea, Malaysia, Mexico, Morocco, Pakistan, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, Turkey and Venezuela.

Sector investing may involve a greater degree of risk than an investment with broader diversification.

This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should purchase or sell any particular security or pursue a particular investment strategy.

International investments are subject to additional risks such as currency fluctuation, political instability and the potential for illiquid markets.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc. Past results are not indicative of future performance.

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Learn more about these funds

AIM Multi-Sector A (IAMSX)

Allianz NFJ International Value Institutional (ANJIX)

American Beacon Large Cap Value Plan (AAGPX)

American Funds New Economy R1 (RNGAX)

Baron Growth (BGRFX)

John Hancock Large Cap Equity I (JLVIX)

Schwab Core Equity (SWANX)

SM&R Alger Aggressive Growth B (SRABX)

SSgA International Stock Selection (SSAIX)

Transamerica Premier Equity Inv (TEQUX)