Investors know the Morningstar rating well. Advisors use this rating, best known as the star rating, to make recommendations to clients. Fund companies use it to market their wares. The star rating is a purely quantitative measure of a fund’s historical risk-adjusted returns versus other funds in its category. That’s helpful, but it only tells you where a fund has been, not where it’s going. This is where our Analyst Rating comes in. The Analyst Rating is a qualitative, forward-looking measure based on our analysts’ fundamental research.
The star rating and Analyst Rating can tell two different stories. Take AGF Emerging Markets, for example. This fund is rated 4 out of 5 stars, but the manager most responsible for its strong long-term return, Patricia Perez Coutts, left in 2012 with nearly her entire team. AGF replaced her with Stephen Way, a veteran investor who had worked closely with Coutts. AGF also rebuilt the team with seasoned analysts. Unfortunately, performance has been poor under Way, and the team still appears to be learning how to work well together. The fund also remains expensive. It’s tough to see which fundamental factors will drive it to long-term outperformance. That explains why we rate the fund Neutral, despite its four-star rating.
On the other hand, Chou Associates has our second-highest Analyst Rating of Silver, but a two-star Morningstar rating. The star rating tells a useful story in this case. Manager Francis Chou is a true-blue value investor who isn’t afraid to underperform for long stretches. The fund’s lousy star rating underscores this point. But the story it doesn’t tell is Chou’s remarkable 30-year record, which remains one of the country’s best. More importantly, Chou continues to execute the same contrarian strategy that made him successful in the first place. His fund’s future is likely to be better than its star rating suggests.
While the star rating may be useful, it’s no substitute for understanding the fundamental drivers that will drive performance, such as the quality of management, the effectiveness of the process, or the competitiveness of fees. The future is more likely to have been written in the fundamentals, not the stars.
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