Fri, 26 Dec 2014
Dodge & Cox International and a handful of Primecap-managed funds offer low costs, stable management, as well as a clear and consistent strategy, says Morningstar's director of fund research.
Christine Benz: Hi, I'm Christine Benz for Morningstar.com. How do fund experts invest their own money? Joining me to share some ideas from his personal portfolio is Russ Kinnel--he's director of manager research for Morningstar. Russ, thank you so much for being here.
Russ Kinnel: Good to be here.
Benz: So, it's great to hear you talk about this topic. I know that you are an avid mutual fund investor. You pay a lot of attention to the mutual fund universe. So, when people think about your portfolio, they think about--I would imagine--some carefully selected ideas. So, let's talk about some unifying themes. When you think about active funds in your portfolio, what are some characteristics that your holdings share?
Kinnel: Obviously, low costs, strong management, consistent clear strategy, and competitive advantages in that combination of people and strategy.
Benz: You also said that another thing you look for is stability. And it's interesting when you look at some of your highest-conviction picks, some of the management companies are owned by the fund managers. Let's talk about why that can help promote managerial stability on the funds.
Kinnel: If a manager has ownership of the firm, one, they have a say in how the firm is run, but two, it also means they have an incentive to stick around. Typically, the setup might be that they buy the shares in early on in their career; and then to get maximum value, they've got to stick around. So, essentially, a meaningful part of their compensation comes in the form of that ownership, and to maximize that position you need to stay to retirement or something close to that. In addition, many of these firms have a mechanism set up that says that when you do leave the firm, or even retire, you have to sell your shares back.
So, that means the next generation of investors at the firm can buy in. And also, it means when the first layer of management retires, instead of selling out to another firm--which may lead to an exodus--they've got to sell back to the same employees. So, it's a tremendous mechanism for stability; and if you look at many of the most stable firms, it's no accident that that's the setup they've got.
Benz: So, you've brought a few funds that you consider your highest-conviction ideas. And you've put your personal money behind these ideas. Three of the funds in your portfolio are run by a single firm, Primecap Management. And you think, in a lot of ways, Primecap really exemplifies what you were just talking about. Let's talk through the thesis for owning three funds from Primecap.
Kinnel: Right. So, as you said, Primecap is owned by management. They've got a tremendous track record of not only people staying around but producing great returns. The way I ended up with three of them was not really by design; but in '98, I bought Vanguard Capital Opportunity (VHCOX) for an IRA account. Later, that option was not available, so I bought Vanguard Primecap Core (VPCCX). And then later, we added Primecap Odyssey Aggressive Growth (POAGX), which is more of a small aggressive-growth fund, to our 401(k)--and I own that. This Odyssey Aggressive Growth Fund is really kind of like what Capital Opportunity was back when I bought it in '98; but over time, that one grew to be more of a large-growth fund.
So, this latest addition still does something different, and I have it in three different accounts. But obviously, when I look at my overall portfolio, I'm factoring in the fact that I've got multiple levels of exposure, so I wouldn't be uncomfortable having that amount of money in one of their funds. Though, I am getting some small- and mid-cap exposure from the one fund and then largely large-cap from the other two.
Benz: So, just briefly discuss Primecap's overall M.O.--what is the strategy that runs through all of these various products that they run?
Kinnel: The firm was founded by managers who left Capital Group, also known as American Funds, and they are growth managers. What that combination means is very deep, fundamental-driven growth strategies. So, looking at where valuations are but going a little deeper. A lot of growth funds maybe use momentum screens; they may be too focused on who's going to beat the next earnings estimates--that kind of thing.
[Primecap] is a little longer term, and they clearly have a competitive advantage. We can see it in the results. We can see how experienced their analysts and managers are. I would add a caveat, though, that the last three years have been so incredibly good that there is no way that's going to continue. So, they like health care, and health care has done tremendously. They like tech, and tech has done well. Those things go in cycles. So, we're just about due for a down period, but I'm going to ride that out, too--almost certainly.
Benz: So, for people who are looking maybe to initiate new positions, they'd want to temper their near-term expectations.
Kinnel: Right. And I would also add that the three funds we mentioned are all closed. There are two Primecap funds still open--Primecap Odyssey Stock (POSKX) and Primecap Odyssey Growth (POGRX). These are in sort of the large-growth, large-blend areas where they feel like they've still got a little bit of capacity.
Benz: So, they're not Vanguard funds, but there are still very low costs in play at these Primecap funds.
Kinnel: That's right. They are still pretty low cost. Obviously, Primecap is running a lot of money, so there is not all that much exclusivity. But to me, they are still about the best growth managers out there. All their funds are rated Gold. So obviously, we believe in them.
Benz: On the value side of the ledger, another firm that you have made a high-conviction holding in your portfolio is Dodge & Cox through Dodge & Cox International (DODFX). Let's talk about why you think Dodge & Cox International exemplifies what fund investors should be looking for in their holdings.
Kinnel: Again, we have a firm where managers own the firm and people tend to make an entire career over there. They come, often, out of business school--whatever--but then they stay their entire career. So, you have very low turnover. They're team-managed--which means even when one person does retire or occasionally leave the firm, you don't have a lot of change. The strategy here--and at all their equity funds--is kind of a relative value. They like fallen growth names. You'll see some tech names like Hewlett-Packard (HPQ) are kind of typical and that it's not the really exciting tech. It's more, "Here's a tech name that's kind of battered but still has market share, still has potential." You'll see drug companies. You'll see some of the better financials. But it's a wide-ranging fund--not super exciting, not super focused--but really well run and also low cost. And one of things that led me to it in '04 was that they were low cost right out of the box.
So, Dodge & Cox--kind of like Primecap--even when the fund's new, they don't charge a high fee, which I think shows an added level of respect for shareholders.
Benz: Absolutely. So, Russ, I'd like to discuss the role of index funds in your portfolio because you say you do have some index funds and you own them alongside the active funds. They are a couple of broad-market index funds. And I'd like your take on what role you think they play in your portfolio--what they do to augment the active funds that you hold.
Kinnel: So, I've got a U.S. total stock market and a foreign-stock index fund. Both are in taxable accounts. Obviously, index funds work well in taxable accounts because they tend not to have capital gains payouts. So, they serve the role of keeping taxes down. They provide a nice, core base that is low maintenance. If I've got some active funds I need to watch closely, then these are funds that I don't need to watch closely. And they lower the costs overall of the portfolio, so it really serves a number of purposes.
People sometimes think we have a strong bias for active or passive. Certainly, I don't in our ratings process or in my own portfolio. I don't see why you can't own both. I think, as Vanguard and many others have said, it's not active versus passive--it's low cost versus high cost. That's what really matters. You want low-cost funds whether you're choosing active or passive.
Benz: Russ, thank you so much for being here to talk about your personal portfolio. We really appreciate it.
Kinnel: You're welcome.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.
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