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A Bear Market to Remember

How it's sparking richer fund analysis.

Karen Dolan, 04/21/2009

Stock and bond markets around the world have perked up lately, but the gloom of the past 18 months still hangs like a low dark cloud. In the years to come, we investors will surely be working to rebuild the nest eggs we've seen fractured--certainly battered, but hopefully we'll emerge a bit wiser.

Individually and as a group, our mutual fund analysts have spent a lot of time reflecting about what has happened over the past 18 months. We didn't predict how deep and severe this current crisis would become, but we're okay with that. We've never attempted to be macroeconomists or market strategists who can tell you where the Dow is headed. Our goal is to guide investors to the industry's best funds, not by focusing solely on what happened in the past, but by understanding how a fund's manager, strategy, fees, portfolio, and stewardship come together to form an investment case. We think we've done a good job achieving our goal over the long haul, but there have been cases along the way where we failed to spot the risk or challenge our own assumptions, as well as those of our readers', about investing in funds.

We've taken countless lessons away from this downturn already and we're still in the middle of learning more. The following four points don't represent a complete list of everything we've learned, but these are among the most noteworthy.

1. Value funds can lose more than you think.
Many, including us, have made the case for value-based investment strategies. Funds scrounging around the markets' bargain bin should offer better downside protection, because ignored and down-and-out stocks trading at discounts should be less susceptible to further declines. Numerous academic studies support the resiliency of value-based strategies, and some of the money managers with the best long-term records are practitioners of some flavor of value investing.

While the losses we've seen in the past 18 months have been deep, they are not the first for value funds. They got clocked by financials in 1990. The average large- and small-cap value fund lost by 6% and 14%, respectively, that year. And, although value funds looked like rock stars versus their punished growth rivals in the 2000-02 bear market, they still posted double-digit losses on average in 2002.

Any illusion of sturdiness for value funds was extinguished in this bear market, however. Value funds have posted steep losses, exceeding the slide experienced by their growth counterparts, the S&P 500 Index and value funds' own history.

I could go on for pages explaining why so many value strategies failed to preserve capital in this tough environment, but two key issues stand out. Most value funds focused too heavily on individual stocks without fully considering the bigger macroeconomic picture, and too many portfolio managers were caught holding companies with balance sheets they apparently didn't fully understand.

At the heart of the problem were the hefty financials-industry stakes in the value equity indexes and common to value funds. (Financial companies represented more than 30% of the Russell Value indexes at the market peak in October 2007.) Financials had been booming for years, so even though the stocks looked reasonably priced on common valuation metrics such as price/earnings and price/book ratios, they were indeed priced for perfection.

We gave a lot of credit (too much, in fact) to managers who were otherwise supposed to be research hounds and financial statement wizards, but who failed to recognize the embedded risks in their bank stock holdings--both in terms of overall leverage risk and asset quality. We're now spending more time finding new ways to stay on top of vulnerabilities that may be lurking in the portfolio and we're bringing an overall more skeptical mindset to our analysis of value strategies.

2. Expenses tell much of the story for bond funds, but not all of it.
Fractions of a percent have typically separated the bond-fund leaders' performance from the laggards'. Given the tight range of returns, we know that small differences in what a fund charges have proven to make a big difference in the end result for investors over the long haul.

In some cases, though, the analysis took that idea too far: cheap fund good, expensive fund bad. Our research has always been much more robust than that, but admittedly, we had a hard time seeing just how different the portfolios of fixed-income funds really were--in part because detailed bond portfolio data can be tough to come by. Until last year, an analysis of returns, interest-rate sensitivity, and sector compositions made bond funds look like they were more in line with each other than was really the case. Moreover, some bond managers really played down the risks of their strategies, often because they viewed them through the lens of some risk-management tool (which I'll tackle in greater detail in the next section).

The risks were there, though, and just waiting to blow some funds to shreds and severely hurt others. My colleague Eric Jacobson recently authored an illuminating article discussing these risks in greater details and highlighting some of the worst offenders.PAGEBREAK

The focus on expenses isn't wrong. Costs remain one of the most predictive nuggets of data we've studied. And, although expense ratios themselves didn't make or break a bond fund in 2008, there was a correlation between expenses and other behaviors that did make or break funds. The numbers confirm it. When you remove the effect of different expense ratios and look at 2008 gross returns, bond funds in the cheapest quartile ranked in the 47th percentile of their peer group while the most expensive quartile ranked in the 55th percentile. In other words, the cheapest funds got themselves into less trouble last year. This isn't a new finding. Morningstar's Don Phillips wrote a research piece about this phenomenon in 1995 called "A Deal with the Devil," where he found that bond funds with the added layer of 12b-1 fees were systematically taking on more risk, as measured by standard deviation. 

Because managers are usually fighting over a couple hundredths of a percent to get ahead of their peers--something many managers are compensated for--funds operating at an expense disadvantage have a greater incentive to take "slightly" more risk to make up ground lost on expenses. When what seemed like slightly more risk turned into a lot more risk, those pricier funds were punished.

Expenses are thus still a cornerstone of our analysis, but we're taking a closer look at the bonds, derivatives, and even questioning the "so-called cash" in portfolios.

3. "Risk management" can and does fail.
Most firms use risk-management techniques. They employ sophisticated models to help summarize and quantify the risks they are taking. They package the output in fancy terms like tracking error and information ratio. However, it's all too easy to lose sight of the fact that risk management is a tool, not a panacea. Too much reliance on risk-measurement systems can and does hurt a fund if management relies on it too blindly. There is no way in which any risk-management system can appropriately account for every possible kind of outcome, especially those outcomes that have never happened in the past.

Firms known for industry-leading bond risk analytics, such as BlackRock and Fidelity, didn't dodge the big problem areas and posted some disappointing results. On the flip side, PIMCO, which also relies heavily on risk models, did much better because the firm has a well-oiled "gut-check" mechanism in place to run counter to what historical data may be signaling. It conducts an annual investment forum where the team of PIMCO investment professionals and invited guests shape their near- and long-term outlooks. Top-down considerations factor into their daily activities, too, leading to a mindset that opened the door for forward-looking inputs to make their way into the firm's risk models.PAGEBREAK

In a recent conversation about this topic, my colleague Eric Jacobson drew a comparison with a fighter pilot. Given the scads of electronics with which they now have to grapple, pilots often develop tunnel vision. A lot of training is therefore built around the need to maintain "situational awareness." At some point, it may become necessary to put the dogfight on hold to just look out the window and realize that you're flying upside down and toward a mountain.

We never gave risk models too much credence unless they were accompanied by a more fundamental and cultural aversion to risk. Yet, we've gained a greater appreciation for the danger risk models can introduce when they become a crutch for managers, leading them to believe they've accounted for the full extent of what could go wrong and not being as honest with shareholders or themselves about what may not be captured by the models.

4. There is a dear price attached to daily liquidity.
Liquidity has taken center stage in this environment. It is a big (and costly) consideration for banks, insurance companies, and corporations carrying debt--as well as for mutual funds. The underlying premise is simple and the same for all of them: If there's a mismatch between demands for money and the ability to supply it, there's vulnerability.

Daily liquidity is one of the best (and worst) things about mutual funds. There's real comfort and convenience in knowing you can cash in your shares on any given business day. But, it also introduces a big risk and one that doesn't often show its face, especially given that mutual funds have experienced money coming in more than they've had to deal with money going out--for decades. In the most extreme (and unlikely) case, all of a mutual fund's shareholders have the right to cash in all of their shares (all at once), but the fund is limited in its ability to turn around and sell its entire portfolio of securities in the open market. Some of the biggest problems have come from funds that were seeing investors flee at a faster clip than they could sell securities to meet those redemptions.

Because this had so rarely been a problem for mutual funds in the past, we did not adequately foresee just how serious a difficulty it could present to the mutual fund structure itself in a time of severe stress. Morningstar is calculating estimated fund flows now, which will help us flag funds facing outsized pressure from outflows. In addition, we plan to keep a more careful eye on portfolio changes from quarter to quarter and ask more about liquidity in manager interviews.

We're carrying all of these lessons into our analysis of mutual funds, but it's important to note that the key tenets of our approach remain the same. We always have and still do rely on a deep dive into a fund's manager, strategy, portfolio, stewardship, and fees to assess a fund's attractiveness for the long haul. We still believe that analysis of those factors leads to better results over long holding periods and that has proven to be the case with our Fund Analyst Picks. At the same time, we recognize there's always room for improvement and we're committed to staying on a continuous learning curve. 

Karen Dolan is Morningstar's director of fund analysis.

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