Only funds with the right recipe make it to our most exclusive list.
By Kunal Kapoor, CFA | 11-18-04 | 06:00 AM | Email Article

As a group, Morningstar analysts are a very serious and committed group of investors. While we each have our individual biases, more often than not, we agree about what makes a good fund. As such, a regular feature on Morningstar.com has been our  Fund Analyst Picks, which represent our best ideas on a category-by-category basis. (We also compile a list of funds  worth avoiding.) These funds share many of the traits of funds we own or would want to own. In fact, many of our own portfolios include funds that make it on this list.

Kunal Kapoor, CFA, is chief executive officer of Morningstar.

So, what exactly are we looking for in a Fund Analyst Pick? For the answers, read on.

Consistent, Thoughtful Strategies
In our experience, successful funds tend to be driven by consistent, repeatable strategies. Nothing draws our ire more than a manager who suddenly switches strategies midstream to either accommodate the market or marketing folks. The reality is that most strategies will hit a rough patch eventually, but the key to long-term success is staying focused on the strategy and riding out those rough patches. For instance, many investors just couldn't fathom why we stood by large-cap value funds such as  American Funds Washington Mutual  and  Oakmark  during the late 1990s, but we did so because of an understanding that there was nothing fundamentally wrong or changed about the funds' strategies, even if the market had moved away from them.

Experienced, Successful Management
Although there are some notable exceptions, we rarely put a fund on our picks list unless management has years of experience. In some ways, this trait is linked to the last point about not switiching strategies, because experienced, successful managers are less prone to get caught up in fads or short-term trends. They are also likely to demand more from newer analysts, deepening the quality of the bench at their firms. In the instances where we don't have experienced managers at the helm of an Analyst Pick, we put a lot more stock in the quality of the organization supporting those managers.

Low Expenses
This is an obvious metric but one we put a great deal of emphasis on. Simply put, we won't buy funds that charge too much. In fact, there are several funds I can think of where we like the strategy and manager, but just won't add it to the list because expenses are too high. Expenses have greater predictive value than any other data point in the fund universe. True, there will always be a handful of costly funds with great performance, but they're less likely to enjoy continued success than those with lower expenses. Realistically, returns on stocks and bonds may be fairly modest for the next decade, so every penny saved in expenses can have a meaningful impact on your bottom line 10 years from now.

Good Fiduciaries
No evaluation of an investment manager is complete without a consideration of whether they are acting in the interests of shareholders. We like to see managers who are compensated based on long-term performance and who invest in the funds they manage, boards that are engaged and communicating with fundholders, and shareholder reports and letters that are honest, thoughtful missives. Those are signs that management cares about its main constituency, the fund's shareholders. As such, no fund with a  Stewardship Grade* below C can make our list.

We're not just doing this because we want to invest with Boy Scouts. These factors can have a big impact on returns. Funds with large sums of managers' money at stake often are managed in a more tax-efficient manner, for instance.

Other Considerations
Investors will note that each category contains an assortment of picks that are often quite different from one another. That's because we recognize that different funds come with different risks, and that it's rare for one fund to be suitable for everyone. We want our Analyst Picks list to be useful to a broad swath of investors, so each category tends to contain an assortment of funds. Nonetheless, we won't just include a fund to add variety to a list. It must rank among our favorites and meet all the criteria we've listed.

Closed funds aren't eligible for inclusion on the list. In fact, any Fund Analyst Pick that closes to new investors immediately comes off our list. That doesn't mean, of course, that we don't like funds such as  Dodge & Cox Stock  and  T. Rowe Price Mid-Cap Growth  anymore. It just means they no longer qualify for what is essentially a buy list. If you own a fund that is dropped from the picks list, we would encourage you to look to the fund's Analyst Report for more follow-up.

We won't always have picks in each category if we're not particularly enthused by the available options. That's long been the case, for example, in the Japan-stock category, but we also don't have picks in the small-cap value group. In the latter case, most of our favorites have closed and we think it makes sense for investors to readjust their expectations to what has otherwise been an extremely hot category.

Similarly, not all categories are suitable for everyone, and we aren't recommending that investors own one fund from each category. Rather, we're offering up choices in a variety of categories and leaving the decision of what may be suitable to investors themselves. In fact, outside of real estate funds, most of us here would agree, for instance, that few investors need to own a sector fund.

It's important to note that Fund Analyst Picks are entirely separate from the Morningstar Rating for funds, which is quantitatively driven. For more on the difference between these two assessments of a fund's worth, click here.

Inside the Process
Each category is assigned to an analyst who gets to know the funds inside and out. We have regular reviews in which the analyst defends his or her recommendations for picks in the category to a four-member committee that consists of director of securities analysis Haywood Kelly, director of fund research Russ Kinnel, associate director of fund analysis Christine Benz, and myself. We vet the analyst recommendations and submit suggestions of our own, eventually deciding with the analyst on what the final choices will be.

* The Morningstar Fiduciary Grade for funds was renamed the Stewardship Grade for funds as of Feb. 7, 2005.

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Kunal Kapoor, CFA has a position in the following securities mentioned above: DODGX Find out about Morningstar's editorial policies.
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