Some One-Star Funds Say Morningstar Itself Deserves Low Rating

Gene Sit admits he’s made some mistakes in the four years since he opened Sit Small Cap Growth.

Three years ago, for instance, the chairman and chief investment officer of Sit Investment Associates in Minneapolis made a bet on a small but fast-growing automation software company, Technomatic, in Israel.

He lost.

The shares lost roughly 30% of their value each year for the next three years. The only thing that stemmed the bleeding was Sit’s recent decision to sell.

Then there’s his decision to over-weight the health-care sector.

Recently, as much as 30% of the small-company growth fund’s assets were invested in micro- and small-cap medical stocks, which apparently didn’t fare as well as their large-cap cousins. Among the stocks Sit invested in were Regeneron Pharmaceuticals, a $242-million biotech company treating neuro-degenerative diseases, and CardioThoracic Systems, an even smaller medical technology company with a market cap of less than $70 million. Over the last two years, those two stocks lost 62% and 82% of their value, respectively. “This can be a humbling profession,� Sit said.

Indeed. Sit’s portfolio is currently among the lowest-rated domestic equity funds, according to Morningstar Inc., the Chicago fund-tracking company that assigned Sit Small Cap Growth a lowly one-star rating, out of a possible five stars. (See accompanying table.)

But it wasn’t his fault. At least that’s Sit’s story, and he’s sticking to it.

Like many managers of cellar-dweller funds who discussed these ratings, Sit says the real blame for the fund’s one-star rating rests not with his stock-picking technique (he seeks out small companies whose earnings are growing more than 20% a year), but rather with the way Morningstar rates funds.

Clearly, some one-star funds earned their way onto the list: Merrill Lynch Dragon B and D shares, for instance, lost more than 57% of their value over the last 12 months; Morgan Stanley Institutional Asian A shares lost nearly 62%; and you’d be hard-pressed to find a gold fund that made a single dollar over the previous one- and three-year periods. (Gold funds, which uniformly performed poorly, are not included in the lowest-rated table.)

But Sit Small Cap Growth gained 17.5% over the last three years. That’s exactly what the average small-company growth fund delivered over the same period, according to Morningstar. Which leads Sit to wonder: “If we were exactly at the midpoint of our peer group, why did we get a one-star rating and not a three?�

The answer lies with the way Morningstar assigns its ratings. Half of Morningstar’s five-star rating system is based on how “risky� a fund is. Morningstar measures risk by determining how much more a fund lost vis-a-vis Treasury bills than its peers over various periods.

The other half of the rating is based on how well a fund has performed on a load-adjusted basis relative to its peers over the last three-, five- and 10-year periods. Herein lies the basis for Sit’s complaint.

While Morningstar categorizes funds fairly specifically, the star ratings are based on four broad categories: domestic stocks, foreign stocks, taxable bonds and municipal bonds.

That means Sit’s small-cap fund was compared not only with other small-company funds, but with other U.S. stock funds as well, including those portfolios that invest exclusively in large blue-chip stocks, the drivers of the bull market for the last three years.

Since Sit’s fund focuses on small U.S. companies, he has had to sell extremely successful companies from time to time as they grew too large. Three years ago, for instance, he sold shares of HBO & Co., a health-care information technology company, when its market cap hit $750 million. Today the company is valued at nearly $15 billion.

For this reason, a number of Morningstar’s lowest-rated domestic stock funds turned out to be small-cap portfolios, many of its lowest-rated international portfolios were heavily invested in Asia, and many of the big losers in the specialty stock category were natural resources funds, hit hard by falling oil prices.

And as a result of a booming bull market--the S&P; 500 returned 30.3% annually over the last three years--a number of funds with seemingly decent performance numbers, like Eaton Vance Special Equities A, which delivered average annual returns of 22.6% and 21.2% over the last one and three years, scored low because of the volatility, not the performance. “Our numbers don’t seem like real bad numbers, do they?� said Jim Naughton, a spokesman for Eaton Vance in Boston.

The star system “punishes funds that invest in out-of-favor sectors,� said Jim Oberweis Jr., co-manager of the Oberweis Emerging Growth Fund, which also received just a single star. “And you could argue that now is exactly the time to be investing in these beaten-down sectors.�

(Of course, that doesn’t explain why his fund, which invests in small-cap companies whose earnings and revenues are growing 30% or more a year, lost 6.7% over the last 12 months and gained only an annualized 8% annually over the last three years, versus annualized gains of 16.9% and 17.5% by its peers during that same time.)

“A one-star rating is cause for concern, but it doesn’t absolutely mean it’s time to sell a fund,’ explained Lake Oswego, Ore., financial planner Glen Clemans. Indeed, Clemans has been putting large amounts of his personal money into funds investing in small-cap stocks and Asia. And for some of his professional clients, he has begun dollar-cost-averaging them into Asian funds investing in beaten-down stocks.

Morningstar agrees investors must consider all the circumstances. “I don’t think it’s wise to base your entire investment decision on a single data point,� Morningstar analyst Russel Kinnel said.

Still, just as a cigar is sometimes just a cigar, some cellar dwellers are there for a reason. Remember, Morningstar’s methodology doesn’t excuse the performance of funds like Dreyfus Premier Aggressive Growth A, which lost 26.8% over the last year, and Rydex Ursa, down 18.6% in the same period.