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Why Low-Rated Mutual Funds Can Still Be a Good Investment

While most investors favor mutual funds with four-or five-star ratings, there may be hidden gems in some of the lower-rated funds.

cnbc.com

That's because a low rating doesn't necessarily mean it's a bad investment.

Morningstar assigns star ratings to funds across multiple investment-style categories based on risk-adjusted returns over three-, five- and ten-year time periods.

Morningstar analyst Jonathan Rahbar explains that funds tend to fall into the two-star camp due to above-average risk, an investment style that goes out of favor or a management change.

“Just because a fund’s been underperforming doesn’t mean it’s not worth owning,’’ says Alex Urbani, of the Chicago investment advisory firm Main Street Advisors.

Urbani started using the Pimco Commodity Real Return Strategy Fund in January 2006 when it was a 1-star rated fund competing against funds with a more narrow focus on oil or gold. Today the fund carries a four-star rating in a more appropriate category of diversified commodity funds.

Understanding Star Ratings/Divining the Stars

5 Stars Top 10% of fund category
4 Stars Next best 22.5% of category
3 Stars Middle 35% of category
2 Stars Lower 22.5% of category
1 Star Bottom 10% of category

To identify some laggard portfolios, CNBC.com combed Morningstar’s fund database across four broad categories—large cap, mid cap, small cap and international equity—for two-star funds with no sales loads, low investment minimums and management in place at least five years.

The four fund picks below court more risk than most and still carry deep wounds from the 2008 bear market. Due to their volatility, they are best deployed as complementary players in an overall asset allocation.

Fidelity Leveraged Company Stock

YTD performance (thru 8/31): -5.85% vs. -2.19% midcap blend avg.

Size: $3.5 billion

Expense Ratio: 0.92%

Manager Tom Soviero sifts through the stocks of financially strapped companies to find businesses with staying power. He currently favors industrial stocks including Celanese and Owens Corning and energy names including AES and El Paso .

His distressed investing style leads to wide performance swings, contributing to the fund’s middling two-star rating.

In a strong economy, where companies can more easily service the junk bonds they issue and earn ratings upgrades, Fidelity Leveraged is one of the top performing, mid-cap funds. It has clocked annual returns in the top 8 percent of its category in six of the last eight years.

Investors, however, must be willing to stomach the wild ride of a fund that is two thirds more volatile than the S&P 500 and susceptible to big losses in downturns—the fund dropped 54 percent during the 2008 fianncial crisis—when highly leveraged companies run the risk of default.

CGM Focus

YTD performance (thru 8/31):-15.66 percent vs. -6.64 percent large-cap growth avg.

Size: $2.5 billion

Expense Ratio: 1.23 percent

You’ve probably heard of Ken Heebner. The manager of CGM Focus garnered headlines for his fast trading, concentrated brand of stock picking before the markets tumbled.

After steering this fund to the top of its category four times since 2000, Heebner has fallen on hard times the last several years with bottom-of-the-barrel returns. Such swings are understandable in a concentrated portfolio that recently included just 18 stocks; both good and bad calls get amplified.

Heebner has bet heavily on Ford Motor , which represents 16 percent of the fund, as well as data storage provider SanDisk , engine maker Cummins and Citigroup while avoiding healthcare and energy stocks.

Given its extended run of lousy performance, now could be a good entry point into the best performing U.S. stock mutual fund over the last 10 years.

Wasatch Small Cap Value

YTD performance (thru 8/31):-3.79 percent vs. -2.94 percent small-cap blend avg.

Size: $193 million

Expense Ratio: 1.97 percent

Utah’s Wasatch Mountains are known for great skiing and the Wasatch Funds complex for great small-cap funds.

Small Cap Value is similar to its Wasatch brethren in its search for companies with strong earnings growth but veteran manager Jim Larkins’ affinity for the tiniest small-cap stocks known as micro caps and his willingness to invest in recovering growth companies makes it one of the firm’s riskier offerings.

While a Wasatch spokesman says a lack of energy and materials stocks has dragged down recent returns, the fund’s ten year record places it in the top 25 percent of small cap funds that own a mix of growth and value stocks.

The fund is currently overweight in the industrial and financial sectors, led by top holdings CorVel , a medical billing firm; aircraft parts maker Heico ; and mortgage REIT MFA Financial . With just $200 million in assets, the fund shouldn’t run into the capacity constraints of owning small caps that can impede performance or force it to close.

Metzler/Payden European Emerging Markets

YTD performance (thru 8/31):-4.99 percent vs. -6.90 percent European stock avg.

Size: $162 million

Expense Ratio: 1.51 percent

Regional emerging markets funds focus on a narrow menu of international stocks and are best used in small portions, advise money managers.

Contrarians convinced that Europe will rebound strongly from its debt woes could be well served in this fund that spreads itself across the developing markets of Eastern Europe with heavy weightings in bank and energy stocks.

Frankfurt-based fund manager Markus Bruck counts Russian oil stocks Lukoil and Gazprom as his top holdings while four banks based in Poland, Hungary and the Czech Republic round out the top ten.

The fund has outperformed its peers, which mostly focus on stocks in Europe’s developed markets, and notched annual returns in the top 13 percent of its category in five of the last six years. A steep 66 percent decline in 2008 and elevated risk profile have pulled down its long-term record.

Short-term performance has a major effect on a fund’s Morningstar rating.

Richard Coppa, a certified financial planner with Wealth Health in Roseland, NJ, says investors need to understand why the fund outperformed or underperformed its peers and consider the impact of large holdings or high cash balances.

You don’t want to throw out a solid ten-year track record, for instance, of a fund that was a caught with a high financials stake just before Lehman Brothers imploded.

Considering the role a two-star fund will play in an allocation is also important. Investors comfortable with frequent rebalancing can benefit from lower-rated funds with strong records in up markets while those favoring more of a buy-and-hold approach may be better off in funds with a steadier performance profile.

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