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Finding the Middle Ground Between Index-Huggers and Gunslingers

Many funds go their own way without the scary ride.

Gregg Wolper, 02/28/2012

Index-hugging has a bad name, and for good reason. It refers to an actively managed fund whose portfolio looks suspiciously like that of the benchmark it tracks. This approach is a reliable way for a manager to post returns that won't offend anyone, such as shareholders or bosses. But they aren't likely to stand out, either. Worse, such funds cost much more than the comparable index fund would.

However, some investors hesitate to buy funds that invest without paying much (or any) heed to their indexes. They say investing with true iconoclasts is too risky, either because of the size of their contrarian bets, the fact that their boldness will backfire at times, or both. Bill Miller at Legg Mason Value LMVTX is typically mentioned as a cautionary example.

But you don't have to invest with someone as daring as Miller or Bruce Berkowitz of Fairholme FAIRX in order to get your money's worth. Many managers steer far away from index-hugging in a subtler manner and have produced long-term results that are not only better than those of comparable funds over time, but with less volatility. Following are a few examples from the international realm.

Invesco International Growth AIIEX
This fund's managers pursue growth investing cautiously, and always keep risk firmly in mind, both in the companies they choose and the prices they'll pay. But they don't care about matching the indexes. The fund's country and sector weightings show that: It has half the weighting in Japan, just 9% of assets, of  Vanguard Developed Markets VDMIX, which tracks the MSCI EAFE Index. The fund has just 10% in financials versus 17% for the index, while its basic materials stake is only half that of the benchmark. Further, the fund's top stock at the end of January 2012 was Compass Group, a U.K.-based catering firm, with 2.3% of assets. That company comes in at number 142 in Vanguard Developed Markets, with just 0.2% of assets. In fact, none of the EAFE fund's top 10 names lands in the top 10 of the Invesco fund.

Despite its insistence on carving out its own path, the fund has not been overly volatile. The fund's Morningstar Risk rating, which measures volatility with an emphasis on the downside, is Low for that period and others. Its 10-year standard deviation is also milder than those of the category and the index. Yet it has posted impressive results. Its 10-year return tops three fourths of the foreign large-growth category and beats the EAFE Index by nearly 2 percentage points. 

Scout International UMBWX  
One of manager Jim Moffett's key goals in running this fund for the past 18 years has been to hold down risk. One method has been to limit the size of individual holdings. Few holdings over the years have received much more than 2% of assets. And Moffett is willing to say he pays attention to index weightings. If he sells a couple of stocks in a certain country or region for company-specific reasons and thus finds himself notably underweight in an area he has no inclination to downplay, he'll look to see if there's a company he could buy to rectify the discrepancy.

That might seem like a recipe for index-hugging. But a look at the fund's portfolio demonstrates otherwise. Two of his top five holdings aren't in the MSCI EAFE Index at all, and the remaining three stocks land between number 100 and number 200 in Vanguard Developed Markets' portfolio. Its stakes in the EAFE Index's two biggest countries, the United Kingdom and Japan, are far below index levels. Unlike most peers, Moffett avoids Chinese companies entirely because he's uncomfortable with that country's investment environment.

The fund's restrained but distinctive approach has produced top-quartile returns for the trailing five-, 10-, and 15-year periods, with volatility milder than the index and peers.

Matthews Pacific TigeMAPTX
With its focus on Asian emerging markets, this fund inevitably is more volatile than the more broadly based funds named above or the MSCI EAFE Index, which is limited to developed markets. But Matthews Pacific Tiger is notably more moderate than the norm in its field. Its Morningstar Risk rating and its standard deviation are milder than the Pacific/Asia ex-Japan Stock category averages over the past 10 years.

The fund's managers aren't afraid to stand out. For example, at year-end 2011 it had more than double the MSCI All Country Asia ex-Japan’s weighting in the consumer-discretionary sector and nearly as large an overweighting in consumer staples, while being deeply underweight in energy, materials, and industrials. Some of its country weightings are equally distinctive: It has 21% of assets in India and Thailand, combined, 10 percentage points more than the index. The fund's number-two holding, with 2.7% of assets, is shopping-mall owner SM Holdings of the Philippines. That stock is buried at number 415 in the portfolio of an exchange-traded fund tracking the fund's benchmark,  iShares MSCI All Country Asia ex-Japan AAXJ, where it gets a paltry 0.05% stake of assets. 

This willingness to distinguish itself has given the fund returns better than the vast majority of its rivals in the Pacific/Asia ex-Japan Stock category over all trailing periods, even with that relatively moderate volatility.

Endnote 
It's worth noting that these are merely examples. There are many funds, domestic as well as international, that have provided shareholders with true active management and long-term success without excessive volatility. If you want to go the active route, and don't feel comfortable with the boldest choices, it's worth the effort to seek these funds out.

Gregg Wolper is an editorial director and senior mutual-fund analyst at Morningstar.
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