Our favorite dividend funds and answers to other Investment Questions!

Director of Mutual Fund Research, Morningstar, Inc

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Q What are your favorite dividend funds?

A Vanguard Dividend Growth and American Funds Washington Mutual are among my favorites.

Q Is this a good time to buy REIT funds?
A Probably not. Yield-chasing investors have driven up the price of REITs to where they are not very attractive in the view of our stock analysts.

Q Is automatic reinvestment by open-end funds a major advantage over exchange-traded funds?
A It’s certainly an advantage–particularly in tax-sheltered funds–though it really depends on how much you use reinvestment.

Q What are some good funds for an IRA?
A I think our Gold-rated funds (other than muni funds) are all pretty good options. Which one is right for you depends on your time horizon.

Q How should you pick a good small-cap fund?
A Look for low expense ratios, strong performance over the entire tenure of the current manager, a sound strategy, and past calendar-year returns and losses that are not too extreme for your own level of risk tolerance.

Q If you bought a small-cap fund that moves to the mid-cap category, should you sell it?
A Probably not. Sometimes small-cap funds move to mid-caps because they are low turnover and bought winners that moved to mid-caps. If that’s the reason, I would probably hold on. If it moved to mid-cap because assets were allowed to grow too much, then I’d bail out.

Q What’s your take on target-date funds?
A I’m a big fan because they adjust your portfolio over time as you reach retirement. The catch is that you need a lot of good funds underlying the target-date fund to make it worthwhile. Vanguard, T. Rowe Price, and American are the cream of the crop.

Q How do you know if a fund manager is any good?
A You have to look at their records, their strategies, and their shareholder reports. At Morningstar, we also talk with the managers and their analysts to better understand their processes and skill sets. Over the years, this has added up to many conversations, and it’s quite an asset in evaluating managers.

Q What do you think of the looming Bond Bubble?
A Bond funds are certainly set up to disappoint as their low yields leave them vulnerable to a rate spike or an inflation spike. Even if those things don’t happen, you’re still collecting skimpy income. With that said, the losses don’t figure to equal those of, say, Internet stocks or housing, as much of the underlying stock in both cases was next to worthless. Treasuries will still be worth something five years from now, so maybe we’re just looking at a couple of years of losses of 5%-10% rather than a meltdown.

Q I have a lot of cash but am overwhelmed by the amount of choices. What should I do?
A The key thing is to build a plan first and then you can research funds. The choices will be a lot easier, and I hope our new Morningstar Analyst Ratings can help you there.

I’ll share some thoughts from the book and movie Touching the Void. A mountain climber has broken his leg and fallen down a gulley. He realizes that he needs to move and fight the urge to avoid decisions and says, “I realized I needed to keep making decisions even if they were the wrong decisions.” I think that applies when investing seems overwhelming. Work on your plan as best you can and then start moving forward.

Q What is the Morningstar Analyst Rating?
A This rating gauges our analysts’ confidence that a fund will outperform its peer group or a relevant benchmark on a risk-adjusted basis over the long term. The rating takes a panoramic view of five key pillars of fund performance:
Process: The fund strategy, competitive advantages, and whether it can be executed consistently
Performance: How the fund has fared and how its track record syncs with its process
People: An assessment of the manager’s talent, tenure, and resources
Parent: Whether the firm puts stewardship ahead of sales
Price: Comparing its value proposition with similar funds sold through similar channels

Q Do you explain why a fund is rated the way it is?
A Yes, we do this on each fund’s analysis page on Morningstar.com and on the one-page reports available toFundInvestor subscribers on the companion site,mfi.morningstar.com.

Q Are ratings adjusted for an investors’ age?
A No, we evaluate a fund on its own merits relative to its benchmark and its peers. We don’t attempt to do financial planning for people.

Q At what point will you have enough data to demonstrate the effectiveness of the ratings?
A To a degree, we already do because we have 12 years of records of our Fund Analyst Picks. Those have beaten their broad benchmarks collectively in every asset class but muni bonds and have beaten their peers about two thirds of the time on average. That said, we do now have more levels of ratings, and I think you need at least five years to really evaluate investment skill.

Q Do you publish a list of lowest to highest fees?
A In our Premium Screener tool, you can rank by expense ratios or simply screen out high-cost funds. In FundInvestor we flag all funds that are in the cheapest quartile of their category. Start a subscription and get key data on the top 500 mutual funds. Buy now »

Q What bond data do you have?
A On the bonds tab of Morningstar.com, you’ll find plenty of corporate-bond data as well as bond calculators.

Q How do you rate a fund that is relatively new?
A We go by what we know but don’t stretch to fill in the gaps of what we don’t know. The biggest factor is a manager’s track record elsewhere. If it’s a new fund but the manager has a long track record someplace else, we may have a lot to go on. If the manager is relatively inexperienced and we don’t have a lot to go on, we’ll likely rate a fund Neutral as we don’t have strong conviction about its chances to outperform or underperform.

Q How often do you reassess funds?
A Typically twice a year, but we will quickly review a fund based on events such as manager changes.

Q How do you identify tax-efficient funds?
A It starts with the strategy. Some funds explicitly say they pay attention to taxes. We can also look at its history to see if it has generally made a lot of taxable distributions. Finally, we can look at the current amount of embedded gains in the portfolio known as the potential capital gains exposure.

Q With world-allocation funds, do you try to differentiate between skill in issue selection and skill in asset selection?
A Yes, we do. We can run attribution on those factors, but it’s often readily apparent from the fund’s strategy as they tend to focus on one or the other.

JPs Thoughts : these are are just some of the major funds discussed here that I agree with..I will bring more thoughts to the Investment round table a little later..jp

Q Are ratings adjusted for an investors’ age?
A No, we evaluate a fund on its own merits relative to its benchmark and its peers. We don’t attempt to do financial planning for people.

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Our favorite dividend funds and answers to other Investment Questions!