The volatility in the S&P 500 Index over the past few weeks serves as a reminder of the importance of reviewing portfolio holdings on a regular basis because, as we have just seen, the fundamentals are fluid. Closely monitoring equity holdings is key to ensuring a portfolio continues to meet an investor's goals and tolerance for risk.
Likewise, mutual funds, too, warrant ongoing analysis to see if their favorable characteristics are still intact following periods of volatility and in the face of shifting market conditions.
Mutual fund rankings, which are key tools for investors and advisers in building and monitoring investment portfolios, need to be able to react to these changing conditions as well. Past performance is obviously one key metric, but there are several others that should be used in order to help determine whether a fund is a five-star, a one-star or something in between.
The strength of a fund's underlying holdings, the length of a manager's tenure and the fund's expense ratio are all factors that need to be weighed in concert with performance to get a true sense of how a fund stacks up against peers. Since launching our new mutual fund ranking methodology in late 2009, we have continued to expand our fund coverage, and now issue reports and rankings on approximately 20,000 funds through our MarketScope Advisor online platform.
In recent weeks, there have been S&P rankings changes of a handful of mutual funds, some positive and some negative, in response to more volatile market conditions and shifting dynamics at the funds that not only affect the funds themselves, but also their underlying holdings.
For example, Wells Fargo Large Company Value Fund (SDVIX) earned S&P five-star status on May 7th. While the portfolio holdings used to develop the fund's ranking did not change, S&P Equity Research's view on some of those holdings did improve; S&P provides both independent qualitative (STARS) and quantitative (Fair Value) rankings on several thousand global stocks, with a ranking of five being the highest (significantly undervalued) and one being the lowest (significantly overvalued).
SDVIX's recent top-10 holding JP Morgan Chase [JPM] had its S&P Fair Value ranking rise to 4 (undervalued), up from a 3 the week prior, while another key holding, Comerica [COM], moved to a Fair Value of 2 (overvalued) from a 1 (significantly overvalued). The fund, which also had an above-average one- and three-year track record as of May 7, saw no significant change in the size or breadth of its holdings; but in S&P's view, the quality of those holdings were enhanced.
To give an indication of how quickly these rankings can change, SDVIX was moved back to 4-star status on May 21st, as a few of the fund's holdings, including Exxon Mobil (XOM), saw their Fair Value rankings decline from 5 to 4; SDVIX continued to outperform its peers on a one- and three-year basis through May 21.
On a percentage basis, changes to fund rankings have consistently hovered in the mid single-digits on a weekly basis. However, when a fund's ranking does change, it is as a result of S&P striving to provide an accurate picture of the fund's prospects and our concerted effort to provide advisers and investors with as much transparency into our approach and findings as possible. Past performance is but one gauge of a mutual fund. If you only looked a fund's three-year performance track record, you might not notice shifts in the fundamentals of your chosen portfolio.
Changes in fundamentals can also extend beyond the holdings. For example, Oppenheimer Capital Appreciation Fund (OPTFX) had its S&P ranking reduced from three star to two on May 14, and remained a two-star fund on May 21, due to changing characteristics of the fund following the introduction of a new manager. In April 2010, portfolio manager Marc Baylin left the fund after four years at the helm, replaced by Julie Van Cleave. Although OPFTX outperformed its peer group in 2009, following two straight years of underperformance, a management change is something that we think should give investors pause and which constitutes a risk in our view. S&P believes that when there is turnover in the manager's chair there is uncertainty as to whether the fund's holdings, investment style and track record are going to change.
That is not to say that all manager changes lead to worsening performance, but we think it is a factor that investors need to consider since a new manager can bring a new approach versus the prior manager. Knowing who is running a fund can be just as important as knowing what equities that fund currently holds.
S&P believes it is important to look at the relative strengths and weaknesses of a fund's holdings, along with other important factors, such as manager tenure, expense ratios and performance characteristics. These are the types of factors that we believe advisers and investors need to investigate and understand before making an investment in a fund, in both calm and volatile markets.
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Todd Rosenbluth is an equity analyst with Standard & Poor's Equity Research Services and helped oversee the creation of S&P's mutual fund ranking methodology. His research can be found on S&P's MarketScope Advisor: http://advisor.marketscope.com. / Note: The fund rankings in this article - from five star (best) to one star (worst) - are quantitatively derived from performance, risk, and cost analysis using a bell curve approach. The stock rankings, or STARS - using a scale of 5-STARS (Strong Buy) to 1-STARS (Strong Sell) - are based on S&P equity analysts' qualitative and fundamentally driven outlook for the stock over the next 12 months.
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