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Where It Could Pay to Be Active

A look at how our 2012 Fund Managers of the Year stack up against their benchmarks.

Michael Herbst, 02/12/2013

Some investors prefer all passive or all active exposure to the markets, yet a growing number are opting for a combination. Some investors seek passive exposure to broad asset classes or specific indexes, such as domestic equity or the Barclays U.S. Aggregate Bond Index, while favoring active managers they believe can add value in narrower or less-efficient pockets of the market. Others scout out active managers with the broadest opportunity set—think global equity or opportunistic fixed income—with the idea that skill plus wide hunting grounds equals better chance of gains. Still others let specific criteria such as expenses, stewardship, or measures of risk-adjusted performance drive the decision-making process.

No matter your approach, the winners of the annual Morningstar Fund Managers of the Year awards make a strong case for active management in their respective corners of the market. Historically, we’ve offered awards for managers investing in domestic stocks, international stocks, and fixed income. In 2012, we introduced awards in two new categories— alternatives and allocation (for managers investing across multiple asset classes) to recognize investors’ growing interests in those areas. Beyond a great year, our winners must be Morningstar Medalists, have generated strong long-term, risk-adjusted returns, and be good stewards of investor capital. No single bet propelled our managers to the top of their categories in 2012, but if there’s a unifying trait, it’s that they’re generally more willing to protect investors on the downside than to try to wring out that last penny of gains amidst rising risks.

While our awards highlight past achievements, we’re confident in each’s long-term prospects, due in part to their deep research resources and willingness to stick with their discipline in good times and bad. To see what these active managers bring to the table, we discuss some of the key differences between their funds and passive vehicles that offer exposure to the managers’ stated benchmarks.

Bill Frels and Mark Henneman have a penchant for companies located within a stone’s throw of their St. Paul, Minn., office, yet many of those have a national or global footprint such as 3M MMM, Target TGT, and Medtronic MDT. The duo values first-hand interaction with company management teams, but ultimately, they seek profitable growers with sustainable competitive advantages and sell when valuations look rich.

The resulting portfolio is similar in some respects to the passive exchange-traded fund iShares Core S&P 500 IVV. The two funds’ recent valuation and profitability metrics—as well as their exposure to the defensive, sensitive, and cyclical equity super sectors— are not decidedly different. Yet due to their stock-selection criteria, Frels and Henneman’s portfolio is heavier on the basic materials, health-care, and industrials sectors; lighter in technology and consumer cyclical stocks; and offers little or no exposure to the energy, communication, or real estate sectors.

The fund scored big wins in two of the tougher sectors in 2012—basic materials and industrials—with long-held positions such as Valspar VAL, Toro TTC, Pentair PNR, and H.B. Fuller FUL. Yet strong performance came across sectors, including wins with Baxter BAX and MTS Systems MTSC.

Management’s ken for the slow and steady means the fund might not keep up in sharp equity market rallies, yet strong downside protection is one of its hallmarks. The fund held up better than most of its large-blend rivals in late 2012’s swoon, and over the trailing decade, it captured only 85% of the S&P 500’s losses. Because of that protection and management’s strong stock selection, the fund has outpaced the S&P 500 in more than 90% of the rolling fiveyear periods over the trailing decade through December. Over that stretch, its 8.6% annualized gain outpaced the S&P 500’s 7.1%, and nearly doubled its bogy’s on a Morningstar risk-adjusted basis.

Rajiv Jain plies a similar approach with his two charges—fairly concentrated, little overlap with his benchmarks, and a relatively cautious growth style. In both Virtus Emerging Markets Opportunities and Virtus Foreign Opportunities, he owns 50 to 60 holdings, with roughly 40% of assets parked in his top 10 holdings. He favors a mix of consumerleading Indian stocks and global firms with a big emerging-markets footprint. In Foreign Opportunities, he keeps one foot in emerging markets (nearly 20% of assets as of Sept. 30) but maintains a broader mix of consumer staples, financial services, and health-care stocks. Both funds’ active share relative to their respective MSCI EAFE and MSCI Emerging Markets benchmarks is over 85%.

Underpinning both funds is Jain’s preference for conservative accounting, strong balance sheets, and his aversion to speculative growth stories. For example, Foreign Opportunities’ average 12.2% return on assets is more than twice the 5.5% of iShares MSCI EAFE Index EFA. Also, Emerging Markets Opportunities’ Morningstar Financial Health Grade is A, which trumps the B– of iShares MSCI Emerging Markets Index EEM.

Jain has also steered clear of a number of emerging-markets accounting scandals, such as those at Sino-Forest and Satyam SAY, which is a testament to his skeptical view of fishy accounting.

Jain’s emphasis on India was a tailwind in 2012, when the average India Equity fund gained 27.5%. Yet a number of his largest Indian positions far surpassed that average, such as ITC, Housing Development Finance, and Hindustan Unilever. In addition, both his funds did relatively well in 2011 when owning India was a huge headwind, which is a further testament to his picks. Lastly, wins from non-India stocks such as SABMiller and HSBC HSBA rounded out Emerging Opportunities’ gains, as did UBS UBS, Novo Nordisk NVO, and Anheuser-Busch Inbev BUD for Foreign Opportunities.

The valuation metrics of Jain’s funds tend to land well above his benchmarks and category rivals, reflecting a dose of price risk, and his funds aren’t cheap. Yet he’s managed the risks of his approach well, with both funds soundly beating their benchmarks over the trailing three, five, and 10-year periods on both an absolute and risk-adjusted basis. Emerging Market Opportunities’ 0.82 Sharpe ratio over the trailing decade trumps the MSCI Emerging Markets Index’s 0.69, while Foreign Opportunities’ 0.64 trumps the MSCI EAFE’s 0.42. On that measure, both funds outpace 90% of their respective category rivals.

As its name implies, this fund focuses more on investment-grade corporate bonds than many of its intermediate-term-bond peers, though not as much as its Barclays U.S. Credit Index benchmark or a small number of corporate-heavy rivals. Instead, skipper Mark Kiesel can lean on other sectors, such as government bonds, mortgages, and emergingmarkets debt, to mitigate risk or scoop up opportunities.

While the fund is shaped by PIMCO’s top-down views, management’s corporate credit selection is a driving force. Kiesel’s long-standing positions in banks and overweight to the energy sector relative to his Barclays U.S. Credit Index benchmark both fueled the fund’s stellar 2012. Yet its top-performing positions crossed sectors and security types, including contingent capital securities issued by Lloyds, bonds from Weyerhaeuser WY, Gazprom, and TNK-BP, and enhanced equipment trust certificates issued by AMR AAMRQ.

Investing in credit at PIMCO can be challenging; credit managers frequently find opportunity in volatile areas of the market that PIMCO as a firm may be attempting to avoid. This past year and over the long term, Kiesel has managed that top-down/bottom-up balance extremely well.

There are a handful of intermediate-term bond funds that offer “purer” investment-grade corporate bond exposure. Investors seeking that purity might opt for iShares Barclays Credit Bond CFT, which tracks the Barclays U.S. Credit Index, or Vanguard Intermediate- Term Investment-Grade VFICX, which sticks pretty close to the Barclays U.S. 5–10 Year Credit Index. Kiesel has outpaced virtually all of his corporate bond rivals on an absolute basis—and beat all of them on a Morningstar risk-adjusted basis—over the trailing three-, five-, and 10-year periods through December. If corporate bond yields continue to shrink, this fund’s deep research resources across sectors and extra dose of flexibility should be welcome. Even so, the appeal of passive funds is that investors seeking dedicated corporate bond exposure will know exactly what they’re getting.

David Giroux has found success in adjusting this fund’s overall allocation and tweaking its asset mix. He generally keeps 55% to 65% of assets in stocks, with a single-digit stake in non-U.S. stocks. (As of Sept. 30, the fund’s stock sleeve weighed in at 62% of assets.) On the fixed-income side, he’s favored convertible bonds in the past, but more recently, he’s leaned on leveraged bank loans to the tune of roughly 10% of assets. Giroux tends to not hold a big cash stake, but he’ll hold cash in lieu of more attractive opportunities, as he’s done lately (11.2% of assets). He also generates a dash of income by writing covered calls on a number of holdings.

Each of the fund’s sleeves contributed to the fund’s performance in 2012. Bank loans had a strong showing, with the average bank loan fund notching a 9.4% gain for the year. This fund got a big boost from its bank loan position in Dunkin Brands in particular. Wins on the stock side came from multiple sectors, including top holdings Thermo Fisher Scientific TMO, Apple AAPL, Walt Disney DIS, and Invesco IVZ. The fund’s cash stake buffered the portfolio during the fourth quarter’s dip.

In spirit, the fund could be viewed as a largely domestic-stock fund with ample breathing room to dial up or dial down equity risk, so its S&P 500 benchmark is a decent but not perfect yardstick. The fund’s fixed-income and cash exposure mean it’s likely to lag that bogy in sharp equity market rallies, but Giroux has done an admirable job since taking the helm in July 2006. Over the trailing five-year period through November, the fund’s 5.5% annualized gain outpaced the S&P 500’s 1.7%, with one fifth less volatility. Over that stretch, it captured 69% of the S&P 500’s downside—on par with its average moderate allocation peers—but 84% of its upside, or 14 percentage points more than its typical rival. Versus a static 60%/40% split between iShares Core S&P 500 IVV and iShares Barclays Credit Bond CFT, the fund outperformed on an annualized basis by 1.3 percentage points with roughly one fifth more volatility.

This fund is the recipient of our first alternatives award. Its management team far outpaced its rivals in the market-neutral category on both an absolute and risk-adjusted basis (as measured by its Sharpe ratio). The fund’s skippers ply a long/short strategy focusing on small-cap stocks and exchangetraded funds—and to a much lesser degree, long-only positions in closed-end funds. It maintains a $1 long/$0.66 short ratio, and aims to keep the fund’s beta at or under 0.3 relative to the S&P 500. Those traits set the fund’s strategy apart from some of its market-neutral peers who target a beta of 0, but the fund’s beta relative to the Russell 2000 (a more appropriate benchmark given the fund’s small-cap focus) weighed in at 0.04 in 2012, suggesting its net equity market exposure didn’t give the fund a huge boost this past year.

That’s not to say the fund’s slightly different take on market neutrality is flawless. For example, its bottom-decile loss in 2008 stemmed in part from its market exposure and holdings that sold off en masse that year. Yet the fund’s 7.9% annualized gain since its September 2004 inception through December tops the category on a Morningstar riskadjusted basis and bests both the Russell 2000 and S&P 500, with roughly half the volatility (as measured by standard deviation).

The fund’s long/short strategy would be tough to replicate via a single passive instrument, but investors seeking vehicles providing lowervolatility equity exposure have a growing number of choices. PowerShares S&P 500 Low Volatility SPLV is relatively new (having launched in May 2011), but its management suggests its beta versus the broad domestic-equity market between 1990 and 2011 would have been 0.5. We’d take that with a grain of salt, and that figure isn’t likely to drop significantly going forward, but it wouldn’t be surprising to see a great number of low volatility or less-correlated passive vehicles come onto the market in coming years.

That said, this fund stands apart from many of its alternatives rivals in other ways as well. Its advisor, TFS Capital, mandates that each portfolio manager invest at least 50% of their liquid net worth in TFS funds; that requirement means its skippers are paying the same high 2.5% expense ratio alongside fund shareholders. Management has also done right by current shareholders by closing the fund to new investors several times. (It is currently closed to new investors.) Investors seeking less-correlated long/short strategies should keep this one on their radar should it reopen in the future.

Morningstar’s 2012 Fund Managers of the Year are great examples of how skillful active managers can add value in their areas of the market. Of course, there is no guarantee that these funds will continue to outperform, but we have confidence in their investing processes and research capabilities. Where they invest will not always be in style, but we feel secure in knowing that these managers will have the discipline and skill to get through the tough times.


Michael Herbst is an associate director of fund analysis with Morningstar.

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