A New Source for Mutual Fund Picks

If you have ever invested or considered investing in a mutual fund, you’ve surely encountered the phrase “past performance is no guarantee of future results.” It’s an omnipresent disclaimer in mutual fund marketing materials; yet investors still tend overwhelmingly to pick their funds on the basis of past performance.

That is why Standard & Poor’s new ranking system for mutual funds is sort of a big deal: It’s the first ranking to rely on more than just returns. Specifically, the rankings will factor in how funds’ individual stock and bond positions stack up against both S&P’s ratings for individual stocks and its credit ratings.

For S&P, the move is a bid to stay relevant. “We’ve seen investors move away from individual stocks to invest more in exchange-traded funds and mutual funds as they try to diversify and keep costs down,” says Todd Rosenbluth, who covers the telecommunications industry for S&P and led the development of the new ranking system.

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Currently, the rankings are only available on S&P’s MarketScope platform, which is marketed to advisers (individuals can request a free trial at www.getmarketscope.com). Rosenbluth can’t give details yet, but he says individual investors who use any of the big online discount brokers can expect to gain access to the rankings, and accompanying research reports, in the near future.

S&P’s new push also represents an attempt to fill a hole in the types of ratings currently available. Morningstar, the dominant force in rating mutual funds, relies primarily on risk-adjusted returns in calculating its influential star rankings. And Lipper determines its “Lipper Leader” rankings based solely on performance. “Past performance should be a starting point in fund analysis, not the end point,” Rosenbluth says.

To be fair, Morningstar does its best to incorporate a good deal of information into its ratings. By “risk-adjusting” returns, it punishes funds that are excessively volatile, with a particular bias against frequent steep drops. Because both Morningstar and Lipper compare fund returns after accounting for expenses, high-cost funds automatically score worse than low-cost funds with similar portfolios.

And Morningstar has always emphasized that its stars shouldn’t be taken as “buy” or “sell” calls, even though investors do seem to use them that way (a 2007 academic study found that, on average, five-star funds garner $34 million in new assets each month, but funds rated three stars or less experience monthly outflows, on average). Indeed, Morningstar’s “analyst picks” are filled with two- and three-star funds and even one fund with just one star.

S&P, by contrast, stews up its new rankings with a complex recipe. In evaluating performance, S&P considers one- and three-year returns, in addition to how funds’ holdings stack up in S&P’s analysts’ eyes (because S&P’s analysts score stocks relative to a price target, funds lose points for holding an overvalued portfolio). In evaluating risk, S&P considers how long a fund’s manager has been on board, the credit ratings of a fund’s bond and stock holdings, and the volatility of past performance, among other factors. And cost considerations account for one-third of a fund’s overall ranking.

You get the sense that S&P is trying to boil the ocean. The greatest weakness of the rankings is that they incorporate so much information that it’s tough to know what to make of them. It’s gratifying, for example, to see that ten members of the Kiplinger 25, the list of our favorite no-load funds, receive five stars. But we wouldn’t recommend selling the worst-rated Kiplinger 25-member, Pimco CommodityRealReturn (symbol PCRDX), just because it receives only two stars from S&P (another weakness of the model is that it can’t analyze the use of derivatives, which bond-king Pimco, for one, relies on heavily in its funds).

But overall, fund nerds like you and me won’t find many surprises in the rankings. And that suggests that the ratings are doing their job -- providing a quick-and-dirty answer that’s in sync with the answer you might come up with through a more-detailed analysis that includes conducting lengthy interviews with fund managers and making subjective judgments about their skills.

As you might expect, ratings from S&P, as well as Morningstar, will occasionally be at odds with our judgment calls. For example, S&P assigns three stars to Dodge & Cox Stock (DODGX) and Loomis Sayles Bond (LSBRX), both of which took a beating during the financial crisis. We kept both on the Kiplinger 25, and each has delivered solid, market-beating gains this year (Dodge & Cox returned 24.6% through October 6, and Loomis Sayles leaped 32%).

One strength of the ranking system is its comprehensiveness -- every U.S. mutual fund receives a rating, even if it is too new to have any performance history (the system is designed to churn out a ranking even when only incomplete information is available).

For now, S&P’s rankings will be most valuable for investors stuck with a list of no-name funds to choose from in their 401(k), or who are interested in investing in a brand-new fund but want a second opinion.

S&P faces an uphill battle in challenging Morningstar’s dominance in the industry. But who knows? S&P will be tracking how its picks perform, so you’ll hear about it if its system turns out to be the better one.