These funds' lackluster recent performance doesn't tell the whole story.
The market rally of the past couple of years has lifted just about all equity mutual funds, but some types have gained more than others. Riskier stocks that rely on borrowing (or otherwise benefit from low interest rates) have generally been among the best performers, and funds that hold a lot of such stocks have outperformed. Among open-end mutual fund categories, the best returns in 2013 came from small-cap funds, especially small growth, and from economically sensitive sector categories such as industrials and consumer cyclicals. This year, the market's rise has been more muted, and the biggest winners have included high-yielding sectors such as utilities, real estate, and energy, all of which also tend to have a lot of debt on their balance sheets.
Left behind the past few years have been many funds focusing on "quality" stocks, generally defined as those that are highly profitable, generate a lot of cash, and have strong balance sheets. (Competitive advantages and good management are other features often associated with such stocks.) Common examples include consumer-product firms like Coca-Cola KO and PepsiCo PEP, drugmakers like Johnson & Johnson JNJ, big oil firms such as Exxon Mobil XOM, and sometimes technology giants such as Microsoft MSFT, Google GOOG, and Apple AAPL. Blue chips such as these have tended to be very good investments over time, but as a group they’ve lagged the broader market in the recent rally. Mutual funds that focus on such stocks have also tended to lag their more-aggressive peers recently, even when they have strong long-term records.
A good example is the $5.2 billion Jensen Quality Growth JENSX. As its name implies, this fund exemplifies a quality-focused growth strategy. Its management team screens the large- and mid-cap universes for companies that have achieved returns on equity of at least 15% in each of the past 10 years, then narrows that group down to a portfolio of 25 to 30 stocks. It has been a very strong long-term performer, with top-decile 15-year returns and far less volatility than the typical large-growth fund, but it has always tended to trail its peers in speculation-driven bull markets. It was among the best-performing large-cap funds in the 2008 downturn but has had a tougher time since then; it trailed about two thirds of its Morningstar Category in 2013 and around 90% so far this year.
How typical is Jensen? We can examine quality-focused funds more broadly in a few different ways. One is by looking at funds that hold a lot of stocks with wide Morningstar Economic Moat Ratings, meaning those with strong competitive advantages that help them maintain their profitability. Another way to measure quality is through a fund's average return on invested capital, a common measure of profitability. Stocks with a high ROIC are, almost by definition, high-quality.
The first table below shows the large-cap domestic-equity funds with the highest percentage of their portfolio in wide-moat stocks, as defined by Morningstar stock analysts. We've limited it to funds with a Morningstar Analyst Rating and show each fund's percentile ranking in its category for the year to date through Sept. 18, 2014; for 2013; and for 2008. The second table ranks the funds according to the average ROIC of their portfolio. It's no coincidence that Jensen Quality Growth ranks third in the first table and tops the second table, one of four funds to appear on both lists.
One thing that immediately jumps out is the performance numbers. As a group, these funds have been terrible recent performers. Of the 16 total funds on the two lists, 12 have trailed their category in both 2013 and 2014, six have ranked in the bottom decile in one or both of these periods, and none have been better than middling over that 21-month span. In sharp contrast, these funds put up stellar relative numbers in 2008; all but three of them ranked in their category’s top quartile that year, with nine landing in the top decile. The only exceptions are RiverPark/Wedgewood RWGIX, which was only launched as a mutual fund in 2010 (though a separate account using the same strategy held up well in 2008), and the two Janus funds, which are much more aggressive than the other funds on these lists but have recently become tamer and more quality-oriented under manager Marc Pinto.
The consistency of this pattern across these otherwise varied funds suggests that their quality focus--the emphasis on wide-moat stocks and/or stocks with high ROICs--has been the biggest factor behind their poor recent results. This is especially true given the funds' Morningstar Analyst Ratings, which include two Gold ratings, eight Silver ratings, three Bronze ratings, and three Neutral ratings. These indicate that Morningstar's analysts consider most of these to be strong funds that are likely to outperform over a full market cycle; in general, they feature solid to excellent long-term returns and long-tenured managers employing disciplined strategies. I cover three funds on this list, all with Silver ratings (ASTON/Montag & Caldwell Growth MCGFX, Dreyfus Appreciation DGAGX, and Amana Growth AMAGX), and that description fits them very well.
Funds like these are best owned by patient investors who are willing to tolerate some short-term underperformance for the long-term benefits. History shows that high-quality investments tend to win out in the end, though it's hard to predict exactly when the tide will turn.