How to make sense of short-term performance when you are a long-term investor.
How should you look at extreme performance in a fund? There’s a natural emotional response to want to invest more in your winners and dump the losers, but that’s not really a good idea. To illustrate the point, I pulled three of the best- and worst-performing Morningstar Medalists based on year-to-date performance.
Funds are best viewed from a great distance. My preferred time period is over the entire tenure of the lead manager. Failing that, 10- or 15-year time periods are ideal provided the management team and strategy have largely remained intact over that stretch. It takes time for skill to show up in fund records, so don’t look for it in year-to-date returns, which are largely noise.
While short-term results won’t tell you much about skill, they do illuminate what kind of fund you own. One of the first things I want to see with extreme performance is whether it fits what I’d have expected. I would not necessarily expect top- or bottom-percentile performance in any seven-month stretch, but some funds are given to extreme performance and therefore it is less surprising.
Another thing to think about is whether the fund has changed its stripes. Has it departed from what I thought it was capable of? I also want to think about what the performance says about the risks of the fund's style at this point in time. Markets rotate and overvaluations tend to self-correct. Therefore, funds with extreme performance are often good bets to make an extreme move in the other direction.
Let’s start with the top three Morningstar Medalists based on relative performance. Each one is in its peer group’s top percentile.
Morgan Stanley Institutional Growth MSEGX is up an impressive 31.6%, tops in the large-growth Morningstar Category. It’s not hard to see why. The fund, with a Morningstar Analyst Rating of Bronze, has a little more than 9% of assets in Amazon.com AMZN and Facebook FB, plus 6.5% in Tesla TSLA and AlphabetGOOG. Lead manager Dennis Lynch has long had a focused portfolio of fast-growing companies, so this performance is encouraging, as this is the sort of year that it should be winning. Over the past 10 years, the fund has had four top-decile performances and three bottom-quartile performances. I wouldn’t be rushing in, though, given the run the FANGs (Facebook, Amazon, Netflix, and Google) have enjoyed.
It’s kind of funny that Royce Opportunity RYPNX would have a big year at the same time that Dennis Lynch’s portfolio is running. For the year to date, Royce Opportunity is up 9.6%, placing it in the top percentile of small-value funds. Small-value funds can be relatively stable and defensive--or they can be like this fund. With big overweightings in basic materials, cyclicals, and technology, this fund tends to jump around the category rankings just like Morgan Stanley Institutional Growth. Its 9.6% year-to-date return is one of the best in the category, but it lost 13.6% in 2015 and also had big losses in 2008 and 2011. Managers Buzz Zaino and Bill Hench simply want cheap stocks, and they clearly don’t mind companies in the midst of a turnaround or industry slump. In short, this fund is doing what you’d expect. In absolute terms, it obviously hasn’t had as big a run as the FANG stocks powering large-growth funds, so I’m not as worried about valuations here.
When equities rally, Fidelity Capital & Income FAGIX often zips to the head of the pack. Manager Mark Notkin invests more in equity than his peers, and he takes on more lower-quality junk bonds than his peers. So, when the economy and stock market are running, you’d expect something like the fund’s 8.3% year-to-date return. It is in the top percentile of high-yield funds for the year-to-date, and it has had two other top-percentile years in the past 10 years. Notkin has done a great job of making the most of these rallies without giving it all back in downturns. But this fund still has more downside than most of its peers. I wouldn’t rush into this fund or really any high-yield fund about now. Although it hasn’t gotten as much press as the stock rally, junk bonds have rallied to a point where spreads over Treasuries are not so far from record lows. Kind of like a momentum stock that has enjoyed a big rally, high-yield bonds figure to sell off sharply with even a modest disappointment.
And the Laggards
JOHCM International Select II JOHAX is slumping in relative terms, though its 15% year-to-date gain sounds pretty solid in isolation. Many foreign markets have outperformed the United States this year, and the dollar has fallen, so funds have to put up pretty big numbers to stay ahead. This Bronze-rated foreign large-growth fund is closed to new investors, so at least we know shareholders were there for some of its outperformance in previous years. This is a bold fund with a focused portfolio, where management doesn’t mind big sector or regional bets. Having underweightings in technology and emerging markets has hurt this year, but the emerging-markets underweighting has helped in the past. A big investment in basic materials and energy, which is unusual for a growth fund, has also hurt. On the plus side, the fund’s record remains strong and it really is sticking to its performance pattern. This isn’t the sort of slump that raises red flags.
IVA International IVIOX is having the sort of underperformance that I find reassuring. The fund is all about defense, so its bottom-percentile 12.2% year-to-date return doesn’t bother me. The fund holds cash, gold, and cheap stocks in an attempt to limit the downside. That said, downside protection obviously comes at a cost. The fund’s five-year returns are also way behind peers. While that isn’t a surprise, it shows this fund requires quite a bit of patience. It has at least consistently done well in downturns. And I like the fact that it closed to new investors before getting too big. I wonder if at some point it will reopen, though it might take a sell-off for that to happen.
Matthews India MINDX isn’t exactly a fund that simply lags in rallies and makes it up in downturns. So, I can’t say I would have expected it to be in last place in a big rally this year. The fund is actually up 26.2% for the year to date, but the average India fund is up a tremendous 33% this year. I’d say the fund is more distinctive than cautious. Management likes steady growers from industries like pharmaceuticals and consumer defensive names, while many of its peers have more cyclical names. In addition, the fund leans toward the small/mid-cap realm much the way many other Matthews funds do. The important thing here is that managers Sharat Shroff and Sumil Asnani are two of the better, more-experienced managers in the group. Shroff has been on this fund for more than 10 years. And the fund’s five- and 10-year returns are among the best in the group. When you see strong long-term results and a consistent strategy, a year of underperformance shouldn’t make you flinch.