Counting Lucky Stars
Michael Santoli
May 14, 2001
The boys in the white lab coats are still trying to isolate the physical source of human smarts and skill, but as yet nothing of the kind has darkened the lens of any microscopes. And so, in attempting to locate and evaluate talent as displayed in a complicated world, we're left with numbers and symbols, the best that the statisticians and quantitative models can offer.
In professional tennis and golf, and in college football, computers now rank the competitors according to borderline-indecipherable webs of performance factors, distilling complex and often subjective activities into a single number. But even here, there's a role for the trained observer, who can decide what pair of players will deliver the most exciting match in a given scenario, regardless of the computer rankings. And as for college football, expert opinion surveys are actually incorporated into the number crunching.
It's worth keeping all this in mind when examining quantitative systems for evaluating mutual funds, specifically Morningstar's five-star regime, the most visible assignor of plaudits and jeers in the business. This system is run entirely by the numbers and has nothing to do with Morningstar analysts' estimation of a fund's suitability for current and future market conditions, the soundness of its strategy or the cut of its manager's jib.
As Morningstar itself makes entirely clear if you click around its Web site enough, the stars simply reflect a combined measure of a fund's exhibited riskiness and past returns in relation to its broad investment category, adjusted for sales charges.
When a fund is old enough, the firm weights its longer-term results more heavily than its recent performance, lending some heft to the star ratings of more tenured portfolios. But with younger vehicles, short-term pops and crashes can swing its tally of stars so dramatically as to render the shorthand emblems of performance nearly irrelevant.
The market's ferocious comeback in April, paced by the more-aggressive pockets of the technology sector, illustrated this point well, as Morningstar, to its credit, pointed out on the Web. A couple of funds that seek to lasso the moon but have recently gotten tangled up themselves -- Berkshire Focus and TCW Galileo Aggressive Growth Equity -- each gained two stars in April alone to finish with five apiece, going from mediocre to elite in 30 days.
Berkshire Focus, a concentrated and volatile tech-soaked fund, did so by gaining 40.44% in April, a jump that still left it down a heaving 46% for the year. TCW Galileo wove a slightly less torturous course, adding 25.25% in April to trim its year-to-date loss to 20.77%.
Two other funds, Delaware Select Growth and Van Wagoner Technology, went from two to four stars after rising 14.18% and 34.12%, respectively, during the month.
As these rating shifts show, the system is by definition backward-looking rather than predictive. And, when it comes to funds that have been around for less than five years, the assigning of stars can appear capricious in fast-moving markets. All the more reason to utilize the stars, if at all, as a starting point, a handy way to screen for funds that have distinguished themselves for one reason or another. This is, in fact, exactly the way Morningstar recommends that its star system be used. Yet it can't be denied that much of Morningstar's success has come from fund companies and investors misinterpreting or miscasting the stars as the imprimatur of quality and virtue.
Mutual-fund executives like to grumble that the industry exists under the tyranny of the system, that investors have nothing but the Morning-stars in their eyes when they make decisions on investments, that there's no hope of having a good-selling fund without at least four stars. Yet the industry is at least as guilty, for making high star ratings a staple of its ads, and for splashing their Web sites with copy noting what percentage of a firm's products have been "awarded" four or five stars.
The problem isn't in the system itself, but rather in the way that investors are led to make important investment decisions by following the same iconography their local paper employs to suggest movies worth seeing or restaurants to try.
T o look at who is winning in the markets and generating investor excitement this year, it would appear it's been decided that the wee will inherit the earth.
Small has upended large in terms of the kind of stocks that are thriving. The Russell 2000 and S&P Small Cap 600 indexes had both gained about 1.3% in 2001 through Thursday, while the S&P 500 and Nasdaq still sat in the red.
More vividly, the tiniest stocks have, almost invisibly, performed a good deal better still. DFA 9-10 Small Company, a fund that passively invests in the wispiest 20% of all stocks in the U.S., was up better than 11% through Thursday, a graphic representation of a couple of thousand little mice roaring. DFA 9-10 is run by Dimensional Fund Advisors, an outfit that puts certain financial-market theories into practice -- such as the idea that micro-caps can outperform -- and only permits a select subset of like-minded advisers sell its funds.
But other micro-cap specialists have gotten in on the fun as well. One that has performed admirably in recent years and is up more than 7% this year is Bjurman Micro-Cap Growth, which announced last week that it would close to new investors when it reached $250 million.
That could happen any day now, with more than $240 million in hand and a couple million flying over the transom every day from investors who've noticed its numbers.
The fund was a rarity in delivering attractive results in both 1999 and 2000, with gains of 53% and 45%, respectively.
Now that the window is closing on Bjurman, the search for worthy alternatives will no doubt begin, though the pros stress that micro caps are best used as diversifying tools as a small part of a portfolio rather than short-term performance vehicles. Phil Edwards, director of fund services at Standard & Poor's, cites a couple of contenders from the ranks of its Select List, made up of funds that S&P analysts have vetted, tracked and found to their liking.
Visit Barron's at www.barrons.com for the latest financial analysis and commentary, updated daily.
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