Beating the index isn’t as easy as it used to be, but this screen can turn up large-blend funds that are up to the task.
Over the past few years, beating the S&P 500 has been a layup for many actively managed funds. Small-cap stocks, mid-caps, and even smaller large caps had, until recently, outperformed, so managers of active funds had only to underweight the giant caps that dominate the index to edge past it.
The tables turned in 2011, however. Owing to fears of an economic slowdown, smalland mid-cap stocks tumbled, while large caps and mega-caps held up relatively better. All of a sudden, beating the index doesn’t look all that simple. Through Dec. 14, the average actively managed large-blend fund in Morningstar’s database had lost about 4.9% for the year to date, whereas S&P 500 Index funds had lost a little more than 3 percentage points less. Most active funds de-emphasize the index’s biggest constituents, and many hold hard-hit foreign stocks, likely explaining at least part of the shortfall.
To help identify large-cap-blend funds that have managed to outperform the S&P 500, we turned to Morningstar Principia.
We started by screening for nonindex large-cap-blend funds that Morningstar covers.
Special Criteria = Distinct Portfolios Only
And Purchase Constraints ≠ Closed-New Investment
And Analysis ≠ N/A
And Morningstar Category = Large Blend
And Special Criteria ≠ Index Funds
Then, we looked for funds that delivered better numbers than the S&P 500’s 1.69% year-to-date loss through Dec. 14. (Advisors could also choose to use the S&P 500’s trailing one-year return.)
And Total Return YTD ≥ -1.69
To help identify short-term outperformers that appear to be good bets on a forwardlooking basis, too, we layered on screens for below-average costs (for 2011 through Nov. 18, the Morningstar large-blend category average expense ratio was 1.14%) and reasonably long manager tenures (five years or better).
And Audited Expense Ratio < 1.14
And Manager Tenure (Longest) ≥ 5.0
Principia returned a list of 34 names. The list showcases what types of stocks held up best in 2011’s volatile market: Nearly all of the funds that made it through our screen emphasize mega-caps, dividend-payers, or both. Here are a few of the most compelling offerings in the screen’s output.
BBH Core Select BBTEX
This valuation-conscious fund’s recent emphasis on companies with steady growth characteristics has put it in the sweet spot of recent market action. With big overweightings in consumer defensive and health-care stocks, the fund has benefited from investors’ appetite for companies that will continue to crank out earnings regardless of the economic climate.
Meanwhile, the managers have downplayed hard-hit cyclical and energy names relative to the fund’s peer group. The fund has more to show for itself than its recently strong performance: With a longtime emphasis on high-quality names trading at reasonable valuations, it has a history of holding up well when stocks are trending down. Its 2008 loss was among the smallest in the largeblend group.
Parnassus Equity Income PRBLX
This socially conscious offering’s passel of dividend payers—which skittish investors have recently gravitated toward—has held it in good stead lately. Like the BBH managers, Parnassus’ Todd Ahlsten favors companies with strong brand names that are selling at reasonable valuations, and stocks like Procter & Gamble PG and CVS Caremark CVS have handily outperformed more-cyclical names thus far this year.
Ahlsten also has a solid record of protecting shareholders’ capital on the downside: The fund’s upside/downside capture ratio statistics show that it has historically gained slightly less than the S&P 500 in up markets but has more than made up that ground during downturns.
T. Rowe Price Dividend Growth PRDGX
Although its dividend isn’t as robust as Vanguard Dividend Growth’s, this offering deserves a seat at the table with other top dividend-focused funds. An emphasis on companies with a history of growing their dividends—and not just stocks whose dividend yields are currently high—helps it avoid value traps.
Manager Tom Huber further ensures quality by focusing on firms with solid management and growth prospects. For the year to date, picks like Pfizer PFE, Accenture ACN, and ExxonMobil XOM have held it in good stead, and performance over the whole of Huber’s tenure has also been impressive.
The list also included two of Morningstar’s perennial favorites; here are some snippets from our Analyst Reports:
Vanguard Dividend Growth VDIGX
This fund keeps its investment universe small by focusing on companies that have long histories of generating enough cash and earnings to support rising dividends. That trait reduces its opportunity set to a few hundred stocks and weeds out more-speculative businesses. Indeed, the fund’s average holding sports a wide moat rating, according to Morningstar stock analysts, as well as above-average returns on equity and belowaverage debt. By these measures, it’s a higher-quality portfolio than those of most domestic-equity funds.
The fund’s clear marching orders allow manager Don Kilbride to focus on the smaller set of stocks that meet his criteria. The fund holds fewer than 50 stocks, virtually all of which pay dividends. Some, such as business database giant Oracle ORCL and recent addition PNC Financial Services PNC, only recently initiated or recovered from cutting their dividends. All of them have the business models, financial strength, and management commitment to increase dividend payments over time. Most of the fund’s money is in companies with positive free cash flow, defensible business models, and powerful brand names, such as Automatic Data Processing ADP in payroll processing and Johnson & Johnson JNJ in health care. Such stalwarts often trade at lofty multiples that reflect their strengths, but Kilbride tries to buy when they are under a cloud. The fund, for example, has added to Microsoft MSFT, Wells Fargo WFC, and Northrop Grumman NOC this year.
This fund is less concentrated now but no less effective. For years Berkshire Hathaway BRK.B made up a fourth or more of its portfolio, perhaps making it appear that much of the fund’s outperformance had been driven by that single stock. Not that there was reason to complain, but it wasn’t clear how much credit the fund’s managers deserved.
The fund has continued to deliver, though, even as it has become less dependent on Berkshire. As part of a broader diversification effort, comanagers Bob Goldfarb and David Poppe have cut Berkshire to 10% of assets from 37% in 2004. If anything, Berkshire has been a slight drag on returns over the past 15 years. The fund has beaten the performance of Berkshire’s stock over that stretch by about 40 basis points annualized through September 2011, while crushing the large-blend average by nearly 4 percentage points annualized.