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Wall Street, California: Third-Quarter Fund Review
and Outlook

What the Tables' Numbers Will Tell You


If you look closely, you'll notice something different about today's special quarter-end mutual fund tables.

We changed the format and the way we categorize the "best-performing" funds. (We'll explain that further down.)

To a casual observer, of course, the most striking difference is that most of the performance numbers have gotten smaller--much smaller. And we're not referring to the size of the type.

The average U.S. diversified stock fund fell 15.2% in the quarter ended Sept. 30, according to independent fund-tracking firm Morningstar Inc. That ranks as the worst performance in eight years.

Clearly, the days when even less-than-diligent research could net you a high-performing fund portfolio are over. Doing your homework is more important now than ever--and that's where our special tables can help.

Rationales Behind the Ratings

First, notice that our list of top-performing funds, starting on the previous page, isn't composed simply of those that did best in the third quarter. Some funds that made the cut, like small growth fund Baron Asset, lost nearly a quarter of their value in the quarter.

Because short-term performance numbers can be deceptive, these tables highlight the best-performing funds over the three years through Sept. 30, factoring in both return and risk.

To compile this list, Morningstar started with its proprietary "category rating" system (which is not to be confused with its famous "star-rating" system).

These category ratings, which you'll see as the first column of each table, assess a fund's risk-adjusted performance over the last three years relative to other funds in its category. The ratings are 1 to 5, with 5 being the best.

For instance, take a look at the Large Growth category. You'll notice that Janus Twenty, the first fund in this table, scores a category rating of 5. This means Morningstar considered this fund one of the best in risk-adjusted returns over the three-year period among those that invest in large domestic growth stocks.

At the same time, Provident Investment Counsel Growth scored a 3, which puts it around the middle of the pack in risk-adjusted performance in its category.

What does "risk-adjusted" mean? Morningstar judges each fund's overall performance against its downside volatility. The idea is that you don't necessarily want to earn the highest returns if a fund also is extremely volatile along the way. Morningstar believes consistency, as well as above-average performance, is also key in judging returns.

Raw performance still matters, of course, so the second column in each table ranks the funds by total return over the last three years, expressed by the percentile in which their performance appears within the category (1-100, with 1 being the top performers).

Finally, the third column is the familiar Morningstar three-year star rating, on a scale of 1 to 5, with 5 being the best.

As with the category ratings, the star ratings are handed out on a "bell curve": The highest-rated 10% of funds get a 5, the next 22.5% get a 4, the next 35% get a 3, the next 22.5% get a 4 and the final 10% get a 1.

Category Rating vs. Star Rating

What's the difference between the category rating and the star rating? In awarding stars, Morningstar compares funds not against others in their specific categories, but rather against others in one of just four much broader groupings: domestic stock funds, international stock funds, taxable bond funds and tax-free bond funds.

What this means, in effect, is that specific categories of funds that are of out of favor in a given period will tend have more funds with lower star ratings. And, conversely, funds in categories that investors have favored lately will tend to have more funds with higher star ratings.

For instance, take a look at the table showing the best-performing Diversified Emerging Markets Funds, on C14. You'll notice that even the best-performing fund in this category scored only 3 stars. And the rest scored just 2.

Why? Emerging-market stocks have been out of favor for much of the last few years. European stock markets, by contrast, have performed well. So within the broad category of international stocks, several European stock funds get 5 stars from Morningstar, while no emerging-market funds come close.

So if you are specifically interested in emerging-market stock funds, the category rating may be more valuable than the star rating, because the former tells you which funds have performed best in that specific category.

Why even bother with the stars, then? Because in a poorly performing category, a star rating can confirm the overall quality of a fund.

For instance, look at the Mid-Cap Growth category, which has suffered recently. Note that 17 funds in this list received category ratings of 5. That means these funds delivered greater returns at less risk, in general, than did their peers.

But although most of them received only 2 or 3 stars, Oak Value, the second fund in the table, was awarded 5 stars.

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