Thu, 9 Apr 2015
Morningstar's Russ Kinnel, Sarah Bush, and Christine Benz highlight their top fund picks for domestic and foreign equity, core bond, inflation-protected securities, and much more.
This following is a replay from the 2015 Morningstar Individual Investor Conference. A full list of all the funds mentioned in this video appears at the end of this transcript. Premium Members: Click here to download a PDF snapshot of Morningstar's take on each fund.
Jeremy Glaser: Hi, I'm Morningstar markets editor Jeremy Glaser, and welcome to our first afternoon session, "Cream of the Crop: Favorite Funds in All Flavors."
I am joined by some of our Morningstar experts to talk about some great fund picks to fill out your portfolio. Just as a reminder, this is a live session, so please keep your questions coming through the player window and we'll trying to answer as many of them as possible throughout the session.
I'd like to introduce our panelists. First is Russ Kinnel; he is the editor of Morningstar FundInvestor newsletter and also the head of our Analyst Rating committee. We have Sarah Bush; she is a senior analyst in the fixed-income space in our manager research. Unfortunately, Shannon Zimmerman couldn't join us today, but we're very fortunate to have Christine Benz, our director of personal finance, sitting in for him. Thank you all for coming.
Russ Kinnel: Good to be here.
Sarah Bush: Thanks for having us.
Christine Benz: Thanks for having us.
Glaser: Let's start by talking about U.S. equity and funds to get exposure to U.S. equities, as this is going to be a major part of most investors' portfolios. Right now, depending on what metric you want to use, U.S. equities look like they are amongst the most expensive in the world and look pretty expensive on an absolute basis as well. What's the right way to think about your equity exposure at a time when market valuations are so high?
Kinnel: I think you want to certainly take that into account because the market has had a tremendous run. Usually, runs don't last forever. We have corrections, and so you want to take that into account. I don't think you want to make a huge bet and say, "Today is the day the market is going down for the next three years." But it means you have to be careful about your allocations. It means you have to be careful about what kinds of funds you have. You don't want a bunch of funds that are all really bullish, aggressive funds meant to make the most of rallies. You want to think about where some conservative funds are. Even if the funds have middling performance, maybe you want to find one that's got more defense. Go back and look at '08; go back and look at the record in the previous bear market. Look for some funds that can hold up well in those environments because the rally is long in the tooth.
Benz: Just to accentuate Russ' point, too, I would say how about good old-fashioned rebalancing? That will achieve a lot of what Russ is talking about. If you are scaling back your equity exposure, because that's what rebalancing will call for in many portfolios today, and then even within that equity exposure, look to your most highly appreciated positions to cut back. So, I think of my own portfolio, a fund that I hold. I know Russ holds it, too: Vanguard Primecap Core (VPCCX). They've had just a fantastic run for several years running. Unfortunately, it's one that would probably be on the chopping block if I were doing rebalancing today because it has had such a good run. So, rebalancing will really get you that valuation sensitivity without you having to make your own determinations about whether the market is cheap or expensive. Just look at the parts of your portfolio that have performed best.
Glaser: So, if you are looking for a more conservative equity fund, what would be some good options? What managers do you think are going to thrive in an environment where returns might be pretty muted?
Kinnel: Well, you can look at high-quality funds because high quality has kind of lagged in this environment for that reason. So, a fund like Dreyfus Appreciation (DGAGX) or Vanguard Dividend Growth (VDIGX); they have some defensive characteristics, not as much as you get in a balanced fund, but I think those are among the sort of funds that have some good defensive characteristics.
Benz: I would add Jensen Quality Growth (JENIX) to that list as well. I ran a screen for funds recently that have very high-quality portfolios and have underperformed recently, and that fund hit the list. It tends to have a big share of what we call wide-moat stocks. It looks for companies that have had high returns on equity over a period of many years, and I think investors should look at those portions of their equity portfolios that have underperformed, like the couple that Russ mentioned as well as Jensen, and potentially steer new dollars there.
Also, when we look at our equity analysts' bottom-up view of the companies they cover, the large-cap value square appears to be the most attractive. Our colleague Tim Strauts did a video on this a couple of week ago. So, that's another thing to potentially look at--dialing your equity portfolio a little bit more heavily toward the large-cap value side of the style box.
Glaser: How about managers that are able to maybe hold a lot of cash? Are you seeing a move toward higher cash holdings than you are used to seeing? Do managers seem worried about these valuations at all?
Kinnel: In the aggregate, no. We're not seeing a big move into cash. There are some, like Longleaf Partners (LLPFX), where they're moving a little more into cash. I think Yacktman's (YACKX) got a fair amount in cash right now. So, there are some who tend to be shy of those high valuations, tend to lag in the really strong rallies who are raising cash. But in the aggregate, we're not seeing a big move.
Glaser: So, if you are worried and you may say, "Well, maybe I should go into cash myself, maybe I shouldn't be buying these equity funds," how has that worked out for investors in the past? Have you seen people really being able to time the market in a meaningful way in the past?
Kinnel: The record is not great, unfortunately. Today isn't the sort of day people tend to sell. They tend to sell after a downturn. So, we look at investor returns, and we see where people really are bad at timing is in those market shocks because they sell at the wrong time and they buy at the wrong time.
So, if you go back to 2008-09, a lot of people were selling after the market got killed and when they obviously should've been buying. And then, more typically, people will buy after big rally. So no, the record of timing is not great, which is another reason we have to admit we're flawed. We're not very good at that timing. Even the best of market-timers out there are not. So, that's another reason to make these sorts of changes at the margins or to do what Christine says and just simply rebalance and just get yourself back to your neutral positioning.
Glaser: So, we've talked about funds for cautious investors. What if you're not so cautious? What if you think either these valuations are reasonable or you have a very long time horizon, and you want a manager who is going to be more aggressive, what would be some good options in that space?
Kinnel: Well, I'll throw out a couple: In U.S. equity, one that I always like is a fund like a Primecap Odyssey Growth (POGRX). People are probably sick of hearing me talk about Primecap, but I have a lot of money in them and I just believe they are outstanding growth investors. Or if you want to look overseas, you could look at a fund like Harding Loevner Emerging Markets (HLEMX). It's not the most aggressive fund out there. It likes high-quality, too. But when you consider the volatility of emerging markets, it still feels pretty aggressive to me, even just a more tame emerging-markets fund.
Benz: In terms of U.S. market exposure, one idea--and I know I will get some boos when I mention this as well, but it's a fund that I personally hold. Longleaf Partners is a fund with a very deep value contrarian bent. Russ mentioned that they have been building cash. They've also got a sizable energy position that has hurt a bit recently. But I do think of them as aggressive value managers. Sometimes, people think that value managers are sort of inherently conservative. Well, these managers are not. They take pretty aggressive stances. They run a portfolio that looks nothing like the market. So, I think of it as sort of a nice complement to, say, a big total-market index fund because the portfolio is so idiosyncratic. But I always think of it as a fund, if there are values to be had, they'll be trying to scout them out. And over the very long term, performance has been good; but certainly in the near term, it's not been great.
Glaser: So, one of the big questions a lot of investors are grappling with in U.S. equity and elsewhere is should I be hiring a manager at all? Should I be looking at an index product? And I know index products have managers; but with an active manager versus a passive one, when does it make sense to really think about an active manager? Is this the kind of market where they might be able to shine, with valuations are so high? Or is this preference for passive--or maybe the outperformance of passive--going to continue?
Kinnel: I think it's really hard to say what's a good time for an active manager and what isn't. I think, for me, it's more about can I find a really good active manager, and at the fee the active manager is charging, do I still like them better than the lowest-cost best index option? So, I think it's much more a matter of the opportunity set available to you. If you don't like that manager enough over the index fund, then go with the index.
Glaser: So, I'd like to take some reader questions here. The first one is about asset bloat. Are there any concerns, either in U.S. equity or elsewhere, of funds just getting too large and not being able to find opportunities to put that money to work?
Kinnel: Yeah. I think there are. I think you do see some funds there that are getting big; but because, in general, we've had redemptions from U.S. equities funds, it's really isolated cases. Normally, this far into a bull market, you have a lot of funds struggling with asset bloat. Today, there aren't that many. We've seen some funds close, which I'm encouraged by. We've seen a number of good small-cap funds like Royce Special Equity (RSEFX) close. So, I'm encouraged by that. American Funds, which is a group that's often associated with asset bloat, most of their funds are still in redemption. So, I'm not too worried, though, if they switched into significant inflows, I would hope they would at least be deliberative of about considering closing.
Bush: This is something we actually watch in the fixed-income markets. I know [PIMCO Total Return (PTTRX)] was one where we were paying very close attention. Because the fund is so much smaller now, maybe it's less of a concern--although it's certainly something to pay attention to. But in more credit-sensitive parts of the market--[for instance,] we saw a big runup in bank-loan assets couple of years ago and in high yield, we've seen a pretty big concentration of assets in some funds--it's something that we're thinking about and watching carefully. Especially if you're really looking for a kind of bond-picker in those markets, it makes it more challenging the bigger the funds get.
Benz: One point I would make, too, about bloat is that even if a fund remains very high on our recommended list--I would think of FPA Crescent (FPACX) as an example. It's a fund that seems to have accustomed itself to having a very large asset pace. But as our analysts have said, that fund strategy is more or less permanently altered because of its size. The fund, in the past, had a big emphasis on small- and mid-cap stocks. It has been successfully playing in large caps, but its strategy is meaningfully different from what it was in the past. So, just because a fund gets large, it doesn't automatically move down in terms of our estimation of it; but it may, in fact, play a different role for investors than it did in the past. With FPA Crescent, for example, I would expect it to be a little bit more correlated with the U.S. equity market than it was historically. So, I think investors, at a minimum, need to bear that in mind--that size can force a change in the manager strategy, even if it's a very capable manager.
Kinnel: Right. I think FPA Crescent is really good fund. We still rate it as a medalist, but I would agree it's a little different. On the plus side, about half of the fund is in cash and consistently has been close to half in cash and bonds, so you have to remember the equity part of the portfolio is more like a $10 billion or $11 billion fund. So, it's not quite as bad as it looks when you just look at that total asset number.
Glaser: I have a question on tax efficiency: How do you think about the efficiency of a fund from a tax standpoint before making an investment? Should it be an important factor when considering a fund or something that's kind of secondary?
Benz: I think it's very important. In fact, I was looking at some of the distributions coming out of active funds in 2014. I would go so far as to say if investors have taxable assets, they should go out of their way to prioritize tax efficiency. A lot of active funds just won't cut it from the standpoint of tax efficiency. These distributions have been very large. So, the good news is that investors have some great tools in their tool kit to manage tax efficiency. Certainly, muni's, which Sarah knows well, but also on the equity side, looking at exchange-traded funds, looking at traditional index funds--especially Vanguard's because Vanguard has its patent on how it runs its index funds and the ETFs are share classes of the index funds--as well as the class of tax-managed funds, which I think have been somewhat ignored but are very, very good. So, these are funds that are actively managed to limit capital gains distributions, and I think that it's a really attractive class of funds that investors ought to be considering.
Glaser: We just finished a video about how we come up with the Morningstar Analyst Rating for funds, and we had a question about why there are some funds that might have 5 stars, that have had good past performance, but that we don't rate as Gold or don't have a Medalist rating at all. How do you think about past performance when selecting a fund? Is it crucial that it has done well in the past?
Kinnel: I don't think it's crucial. I think you want a manager who, generally, who has done well in the past, but that might not sync up with the fund record. Say you have a manager who did well elsewhere but they just started on this fund, so you have a disconnect right there. Also, the star rating looks at three-, five-, and 10-year periods. But let's say the manager has a 15-year record or maybe the manager started a year ago and the fund is 5 stars because the predecessor had a good performance. So, those are among the reasons you'll see a disconnect.
I think the most important is that manager's track record, but also do you think that that manager can continue to succeed? And then, in terms of coverage list, the star rating is updated monthly. So, say we were to just cover 5-star funds, we would constantly be shuffling through our coverage list because funds move on and off a lot. But we know a lot of our readers want consistent coverage of big funds; if we said this fund was great and it happens to fall to 4 or 3 stars, that doesn't mean we should stop covering it. So, there are some good reasons why it's not perfectly in sync.
Bush: And on the fixed-income side: One of the things we've seen since we've been coming off those lows in 2008--we've had a really strong rally for most of that period in credit--is that a lot of the funds that looked good from a star-rating perspective now are funds that have taken more credit risk or taken more liquidity risk. So, we want to put that performance record in context and understand what risks are being taken. And obviously, the star rating does risk-adjust, but when you get a really strong run for an extended period of time in one type of asset, sometimes you need to look a little bit deeper and understand where that performance is coming from.
Benz: One thing I think about, too, when I look at past performance is that I want the fund to have performed well at some point in the past; but typically, when I look at new purchases, I'm kind of looking at the things that haven't performed as well. I want my tried-and-true fund, and I want to buy it when it's a little bit in the dumps. So, that's kind of how I think about it.
I also look for predictability of performance. Is this investment performing well or poorly when I would expect it to? In the market environment in which I know it should perform well, I want it to be delivering, but I don't expect any fund to be truly all-weather. That's unrealistic. Unfortunately, it's something a lot of investors have in mind with fund selection; they are thinking about all-weather performance. I think that the only way you get all-weather performance is by building a diversified portfolio of various things that act differently.
Kinnel: I would add, too--just to back Christine's point--if you look at the trailing returns at three, five, and 10 [years], and let's say they are all really strong, you might think it's been smooth sailing for this fund all along. But that's where the calendar-year returns are really useful, so you can go back and see what was the worst single-year loss was for this fund and see how volatile were the returns, what was the environment--because even if it's got a great three, five, and 10, it might have gotten blown out of the water in '08. So, there is a lot of really good information in that performance record; it's just not necessarily the best predictor.
Benz: To Sarah's point, Loomis Sayles Bond (LSBRX), which is a fund I often recommend for noncore fixed-income exposure, had a terrible 2008 performance but beautiful-looking trailing returns. Everything looks perfect for that fund, unless you drill into that bad year, and it was an awful year.
Bush: Right. And as you know, that fund, in particular, did very well. It made lemonade out of lemons, but you need to have held the fund during that time period. So, if you are not looking at those tough periods and you're not going to be able to stick with the fund, you are not going to get those returns that they do so well in over the long term.
Glaser: Let's turn our gaze outside of the United States and into foreign investments. What's the general consensus or the general thoughts amongst the managers that you follow about the opportunity set outside of the U.S. right now? Do those markets look relatively more attractive?
Kinnel: Yeah, that's what I'm hearing. In particular, I hear about interest in Europe and emerging markets. So, obviously, Europe is having its own issues. It started its own quantitative easing. The euro, outside of a couple of days ago, has been getting hammered. So, to a lot of people, valuations are cheap and there is obviously the potential that you could have economic improvement. Emerging markets, obviously, it's a mixed bag; but by and large, a lot of people say you have greater growth potential and more reasonable valuation, so there is a lot of appeal there. Though, of course, if you go in and look at the emerging markets, country by country, you'll see that Brazil has problems, Eastern Europe has problems. So, obviously, it's not all one cohesive group.
Benz: One thing I recently did was I looked at our highly rated world-allocation funds. These are the go-anywhere funds that can buy bonds; they can buy stocks globally. They can also hold cash. I was kind of looking at where the better world-allocation go-anywhere funds are making their bets. Two things jumped out. One is that they had more cash than the average in their peer group. So, most of the ones we like are kind of valuation-conscious. They were maybe holding cash because they don't think securities are super cheap right now. But foreign stocks were a big emphasis relative to U.S. for all of those Gold-rated world-allocation funds that we cover. So, I thought that was kind of an interesting takeaway if you look at managers who have the latitude to go anywhere. They seem to be emphasizing foreign stocks at the expense of U.S.
Kinnel: If you want to make a really contrarian bet, PIMCO All Asset All Authority (PAUAX), Rob Arnott's fund. He loves [emerging markets]; he doesn't like the U.S. So, as you might guess, recent performance has been terrible; but he is a good allocator. I think if you're a real contrarian, that's not a bad one to look at.
Benz: I heard Ben Inker from GMO speak at our Institutional Conference a couple of weeks ago. It was GMO, so they had a very sobering perspective on everything. But GMO does think developing markets are a pocket of opportunity for investors in an overvalued market right now--and specifically, if you can look at the value slice of emerging markets, they think that's the area to look at. A lot of what I think Ben Inker called "dumb, old companies," a lot of the value-oriented industrials--maybe energy companies would fit there, too. Companies that are not particularly compelling from a growth perspective, [GMO] thinks that they are nice and cheap, so investors have that margin of safety.
Glaser: Of course, one of the big stories for investors outside the U.S. has been the strength of the U.S. dollar--really one of the biggest moves we've seen in quite some time. How do you think about currency risk? Is it worth seeking out a manager that's hedging away that currency risk, or is that really what you are trying to gain exposure to as well when you are looking abroad?
Kinnel: I think you certainly want to understand your portfolio's currency risk; I think there is some value in having currency diversification. Only right now, of course, the catch is that the table appears to be set for the dollar to continue strengthening, so you might consider some funds that do hedge their currency if you want to dial down the risk that the dollar does strengthen. So, I think of funds like Tweedy, Browne Global Value (TBGVX), Vanguard Global Minimum Volatility (VMVFX), PIMCO Foreign Bond (USD-Hedged) (PFORX). These are all funds that hedge away most of that exposure. So, it's a way to invest overseas, but if the dollar does rally the next year or two, you should be protected. Now, longer term, it's less important because those kinds of moves tend to wash out.
Benz: One thing I think it's important to remember--and this came up when our colleague Kevin McDevitt wrote a great piece about foreign funds. So, foreign funds have obviously underperformed U.S. over the past several years, but what Kevin looked at is that these markets haven't performed that badly; it's mainly that the dollar has appreciated versus other developed-markets currencies. So, a lot of the reason that investors' foreign-stock holdings have underperformed is a currency effect. So, it's really important, as Russ said, for people to understand their fund's hedging policies or perhaps lack thereof.
Bush: It's interesting. You may wonder, "Where are the obvious places you get currency?" Foreign-stock funds, foreign-bond funds, the N-bond funds. We actually see some core bond funds taking fairly active currency positions. Some of the Loomis Sayles funds have had a rough year because of some exposure outside the dollar; PIMCO has been on the other side of that trade with Total Return, which had been long the U.S. dollar, and that's been a positive for them.
Glaser: I'd like to get to some user questions in this area. The first one actually is for you, Sarah, about foreign bonds. Does it make sense to hold foreign bonds and if so, what are some of your favorite ideas in that space?
Bush: I think the question there gets back to the one we were talking about regarding how currency volatility can really, in a bond portfolio, outweigh a lot of what else is going on. So, I think you need to be aware of where else the currency risk is coming from. So, I think it is tough to hold those non-U.S. dollar foreign-bond funds. If you are looking at ones that are hedged, I think that can be a nice sort of satellite holding within a bond portfolio. PIMCO Foreign Bond is one. There was a manager change there when Bill Gross left the firm. We still have a Bronze rating on that. Then, also, on the emerging-markets side, which is a little bit more of a contrarian play today, Fidelity New Markets Income (FNMIX) is another one without the foreign-currency exposure.
Kinnel: Which is run by former [Morningstar Fund Manager of the Year], John Carlson.
Bush: And that fund has been around for a long time. That category has grown a lot, but that's one of the oldies in that group.
Benz: One thing I would say, too, on the foreign-currency/foreign-bond front is that when we look at the allocations recommended by our colleagues under the Ibbotson umbrella, people working on asset allocation here, one thing that they do is that they might include some foreign-bond exposure for younger investors, but they definitely back off of that for people getting close to retirement. And the idea is that when you're getting close to retirement, when you are getting close to spending your money, you don't need the wild currency fluctuations that can accompany unhedged foreign-bond portfolios; you need to get that money queued up to be spending money, and so you want to take less risk with it.
Glaser: We have a question specifically about Japan and about managers who are either finding value right now in that market or who are Japan-focused. What are some of your favorite picks for investors looking for Japanese exposure?
Kinnel: That's a challenge. Not many managers like Japan anymore. The first thing that came to mind when you mentioned Japan was how Longleaf has sworn off Japan after a bad experience. So, I'm going to have to ponder that one from a moment, I'm afraid.
Benz: Hasn't David Herro historically looked at Japan?
Kinnel: Yeah, Oakmark International (OAKIX), I think, has some Japan holdings. And in general, it's a value play. It's only been in a 20-year slump, so you really have to be a value investor to go there. I think sometimes Mark Yockey at Artisan International (ARTIX) will also go into Japan, but I can't recall his Japan weighting off the top of my head.
Glaser: And then looking across the style box abroad, we had some questions about whether it makes sense to try to get more small-cap exposure, even micro-cap exposure, and get away from some of these multinational mega-caps in these foreign markets. Is that a strategy that you've seen be successful over time?
Kinnel: That person is right. So, when you go into small caps, generally you are getting much more local economic exposure; whereas with the giant companies--if you're looking at Caterpillar or a drug company or something like that--it barely even matters where they are located. So, for instance, if you're looking at small caps, DFA has an international small-cap/micro-cap fund that is a good option if you want to get that exposure. There aren't a lot of micro-cap foreign funds other than the DFA fund. But it's not a bad idea if you want a little more diversification. They're going to behave a little differently. They're probably going to be a little more economically sensitive and probably a little more volatile.
Glaser: So, getting back to that active/passive question that we asked for U.S. equity, we have a follow-up to that for foreign equity. We see in the fund flows that it seems that investors are more comfortable having active management in emerging markets, in some foreign companies. They want that hand on the wheel. Does the data bear that out? Does it make sense to have active management maybe in emerging markets and to think less about the indexes in these spaces?
Kinnel: I think there is a valid point for both. Again, I'm kind of agnostic about where you index and where you don't. I think that passive is still a good approach. One of the things [to keep in mind about] emerging markets: Most of those funds charge much more than a U.S. fund. So, the passive options in emerging markets actually have a greater lead in terms of fees. So, there are some advantages to it, but certainly there are good options in both active and passive.
Benz: I think tax efficiency here is a consideration as well. If you're holding the investment in some sort of a taxable account--even though foreign-stock index funds tend to have pretty high dividend yields, which you're going to pay taxes on in a taxable account--I think you will tend to be more tax-efficient in the index product versus the active product. You won't have those capital gains distributions coming when you didn't expect them. You'll have more control over your tax positions. So, that's another factor to bear in mind. But I think when you look at the data on foreign-stock indexing, they've done just fine relative to active funds.
Glaser: Well, it's time to talk about fixed income a little bit. I know Sarah is excited. I guess the first question really is that it seems like, for a couple of years now, we've been predicting that rising rates are almost here, and now this year maybe it seems like they are actually almost here. Bond funds have done pretty well over the last few years, despite predictions that they wouln't. How do you think about your bond exposure then, today, given that this interest-rate risk is so prominent in investors' minds?
Bush: It's probably even been more than a couple of years [that we've been hearing about rising rates]. We were hearing these stories back five, six, seven years. I want to piggyback on something Christine said in an earlier session. I think it really is about what you are using your bond exposure for. So, I think for a lot of people looking from a full-portfolio prospective, bonds are providing that stability in stock market sell-offs. They're kind of a counterweight, and I'm thinking about high-quality bonds here. They are a counterweight to that volatility that you're going to see in the rest of your portfolio. So, I think they continue to play that role. It's certainly not attractive to look at those yields, especially if you look at where they've been historically. But I think that that's an important consideration to take when you're looking at that piece.
Glaser: When you're looking to fill that core bond exposure, a lot of people turn to Bill Gross and to PIMCO to do that. We mentioned, obviously, his departure. A lot of money has departed Total Return. What's your current take on Total Return and what are some other alternatives if investors feel like they want to look elsewhere for that core bond exposure?
Bush: So, when Bill Gross left PIMCO Total Return, we lowered its Morningstar Analyst Rating to Bronze. And that reflected a couple of things. First of all, there's still a lot of good stuff going on at PIMCO. This is one of, if not the most, well-resourced [fund companies]. There are just a lot of really smart people there. They've got a lot of people and a lot of resources to kind of figure out how to do bond management well, and a lot of those people were already contributing to the record that PIMCO Total Return had over the long haul.
So, that's definitely on the positive side. And in terms of tempering that rating, obviously there has been the manager turnover; we now have a three-manager portfolio model, so that's a little bit new. We've had changes to the investment committee, which are very important in terms of how the positioning of the fund plays out. So, there are some question marks there. And then, obviously, outflows. There's just no way of sugar-coating it; the outflows have really been significant and they have continued. I think we've sort of seen PIMCO suggest they're going to slow down a little bit in the press, and we've seen that kind of happening in some of the competitor funds. So, we do retain that Bronze rating. We do still think that that's a fund that has that potential to outperform, but there are still some questions in the short to intermediate term.
In terms of alternatives for people looking for core bond exposure--these are funds that are typically in our intermediate-term bond category--Metropolitan West Total Return (MWTRX). It's taken in a huge amount of assets, but it's still one of our Gold-rated funds in the category--one that we really like for that broad-based exposure and its willingness to go in and be a little contrarian when there is an opportunity to do so.
Another one that we like in that space is Dodge & Cox Income. That one has been a little bit more corporate-heavy. So, it can have a little bit more weakness in a 2008 environment, but it's a very cheap fund, very stable, long-tenured team running it, very straightforward low-turnover approach to fixed-income investing.
Kinnel: Much duller and fewer derivatives is their style. If you want a bond fund that just goes out and buys corporate bonds as well as mortgages and other things, too, it's a more straightforward, basic approach.
Bush: Right. And then, obviously, there is also index exposure in that space, and we've seen Vanguard Total Bond Market Index (VBMFX) taking a lot of flows as well.
Glaser: And what kind of a different performance could you expect from, say, a bond index that maybe is tracking the Barclays Aggregate versus an actively managed fund? Would you think that those are going to be pretty different?
Bush: So, if you look at the full spectrum of the intermediate-term bond category, you really are seeing a lot of funds, not all of them, but a lot of funds taking on more corporate credit risk, both investment-grade and then also high yield, emerging markets. As I mentioned earlier, some of the Loomis Sayles portfolios have some foreign-currency exposure. So, I think you really need to know where you are in that space. A lot of the funds that are doing that are going to be more volatile in credit sell-offs. The bond index has a lot of government exposure. It has, however--and, again, I know Christine mentioned this earlier--it has really proven its worth in periods of stock market volatility and flights to quality.
Glaser: You mentioned intermediate-term bond managers are kind of looking at high yield--so are a lot of investors. They may be willing to take on a little bit of credit risk to mitigate some of that interest-rate risk. Do you think everyone is aware of the risk that they are taking on here? And how would you expect these funds to perform in a time of market stress?
Bush: So, high yield is really kind of a hybrid in between high-quality investment-grade bonds and equities. And, in fact, high yield tends to perform kind of directionally like equities. I think the high-yield category was down something like 30% in 2008. So, I certainly think that they can play a satellite role in terms of a portfolio, but you're not going to be able to count on them to provide the same diversification as a high-quality fund would.
Kinnel: And picking up on our theme that everything is pricey: High yield is another thing that's been bid up. So, again, the yields are not as great and the margin of safety is not as great. So, high yield is useful, but again, it's another thing that's really been bid up. Pretty much anything with a yield has been bid up tremendously over the last seven years.
Glaser: So, what are some of our favorite high-yield funds?
Bush: Fidelity High Income (SPHIX) is one that we like quite a bit. And this is an interesting one because, again, within the high-yield category, a lot of the funds that have done best, at least until the last six months or so, are the ones that have taken on the most risk. This is one that's kind of in the middle of the risk spectrum, and it's been trading kind of close to the middle of the category. However, it really has kind of proven itself in broader dislocations in the high-yield market, and we like it. It has reasonable expenses, a very long-tenured manager, and a lot of analyst resources.
Benz: One strategy I like, too, rather than trying to figure out what's the right amount I should have in high-yield and developing-markets debt and all of these other noncore fixed-income categories, I like the more go-anywhere aggressive bond funds for the longer-term piece of an investor's bond portfolio. Loomis Sayles would be a great example of that. I know Fidelity has a product along those lines, too. But I like delegating that.
Bush: Fidelity Total Bond (FTBFX), as you mentioned, that's a fund in the Fidelity lineup, and Fidelity doesn't make interest-rates bets. So, they're not doing that piece, but it can hold emerging markets; it can hold high yield. It's made some big allocations over time, moving around between corporates and mortgages. So, you're letting them make that relative value decision for you. Kind of an all-in-one [fund], a one-stop shop.
Glaser: We have a user question about municipal bonds. If you're looking at muni funds, does that play a role in taxable portfolios? What do valuations look like right now?
Bush: It certainly can play a role on a taxable portfolio; that's what people are looking to them to do. Valuations, there--I think everything is stretched. They had a rough 2013. So, I think there is still some value there. I was looking at what the credit-quality profile is there; despite some big stories around Detroit and Puerto Rico, I think that, in general, the credit quality of the municipal world is doing pretty well, pretty stable. There is still plenty of interest-rate risk, though. So, that's just something to be aware of. In terms of funds we like in that space, Vanguard has some very cheap funds that have done well and don't take on a ton of risk, and then Fidelity has also got a great lineup.
Glaser: We've had, I don't know if I'll call it a flood, but a lot of questions today about TIPS funds and inflation protection, generally. Are TIPS really the best way to immunize your portfolio against inflation? Or are they just too expensive to be able to do that job effectively?
Bush: Well, actually, one of the things we've been hearing from a lot of more-diversified managers is that TIPS are really attractive right now from a valuation standpoint. So, I think they can play a role. You can obviously go out and buy a TIPS fund directly. [Vanguard Inflation-Protected Securities (VIPSX)] is a fairly straightforward one that we have. That's a fairly cheap option that you can look to there. But again, going back to Christine's point about high yield, you do see managers with that broader tool kit. I wouldn't say go-anywhere, but kind of broad-based core-plus funds, and they will use TIPS in their tool kit. And I kind of like to see that because, again, they're kind of making those decisions about relative value for you.
Benz: One fund that I recommend--in fact, it's in my model portfolios--is Vanguard Short-Term Inflation-Protected Bond Fund (VTIPX). One thing I like about Vanguard is that they usually do research to support whatever new product that they are about to launch or research precedes the fund launch, "Here's why we're doing this." And so before they came out with the short-term TIPS fund, what they looked at was the core-type TIPS fund, in addition to providing that principle adjustment that you get with a TIPS fund when inflation picks up, you also get a lot of interest-rate-related volatility. So, TIPS have pretty long durations. They also have liquidity issues; we saw in '08, unlike other types of Treasury bonds, they sold off because there was sort of a liquidity shock. So, I like the [Vanguard Short-Term Inflation-Protected] fund because it sort of isolates the inflation protection and downplays the interest-rate-related volatility, and it sticks with the short-term TIPS. So, that's a fund that I recommend for people who just really want to add a little bit of inflation protection to their fixed-income portfolio without all that rate-related volatility.
Bush: And just pick up on that: That is a point to make about TIPS. I think a lot of times people think, "Well, it's got inflation protection; you don't need to worry about interest rates." And TIPS funds, especially the ones that are kind of the full market and are looking out to longer maturities, they can be very volatile. They got completely hammered in 2013. So, it's something to be aware of when you're looking at those funds.
Kinnel: That was my point.
Bush: And I'll just pick one more there. I did mention the plain-vanilla TIPS funds. There are some that take a little bit of a broader view to the inflation-protected market, so there are securities you can buy outside of the U.S. For instance, PIMCO Real Return (PRRRX). Harbor also has a version of that, [Harbor Real Return (HARRX)]. That one is a little bit more adventurous in terms of the range of inflation protection they provide.
Benz: More broadly, I would say that if there's a contrarian idea out there, one is that maybe inflation-protecting instruments are cheap right now. So, when you look across the gamut of categories, TIPS and commodities have performed well at all. I'm not saying that they're necessarily cheap because it's kind of impossible to know; but certainly when you think of reversion to the mean, commodities may be due for a rebound. Precious-metals equities have had a very rough go of it. I'm not saying that any of these categories should be a large part of anyone's portfolios. TIPS should arguably be the largest, but there may be sort of a contrarian idea there for people who want to take a portion of their portfolio and move it into things that are deeply unloved. Anything with inflation-fighting properties has been very much overlooked and beaten down.
Glaser: Having very low inflation, often, can help focus people away from it. Getting back a little bit to a noncore bond category: bank loans. We have a couple of questions here about whether this a good time for bank loans.
Bush: We've seen flows. I think they tailed off a little last year, but there's been a lot interest in bank loans over the last three to five years. One of the reasons is pretty obvious: Bank loans have floating rates. They readjust periodically to a spread over Libor, so if you're worried about rising interest rates, bank loans provide some protection against that.
A couple of things to point out: One is that the way those loans are set up, they readjust over short-term rates; so we'd really have to see a big rise in short-term rates to see the adjustment up. Then, the other piece to be aware of is that there is a lot of credit risk in these bank loans. So, they're not quite as risky as high-yield bonds in terms of credit risk, but they're largely to junk-rated issuers. So, they did badly in 2008. They may not provide the same kind of diversification if you're looking at them across a big part of your bond portfolio.
Kinnel: One of the things I worry about with bank-loan funds is that the group has grown tremendously. And what happens if flows start going the other way? Because it's not the most liquid part of the bond world. So, we really don't know what will happen the next time bank loans have a real correction.
Glaser: A theme I've heard a few times here is that sometimes it's nice to have a manager who is making that decision about when it's time for bank loans or time for adding TIPS. That brings us to allocation funds--target-date funds, funds of fund--where managers do have more discretion there. What are your thoughts about looking at those types of our products versus trying to create these portfolios yourself? Is that a strategy that's going to work for a lot of people?
Kinnel: I think so. When we do the "Mind the Gap" study on investor returns, we've seen that people have really done well with target-date funds because they own them in 401(k)s where they are consistently investing every paycheck. And so far, it seems like people really have stuck to that plan, and that's exactly what you need to do. Not only do they get you tremendous diversification, they are adjusted over time as you get close to retirement age.
But also they are really boring. You are super diversified. If you look at the annual returns of those versus some of the wackier funds we've talked about, they tend not to move that much, especially if it's one that's close to a 50-50 [stock-bond] split. That's actually good because it doesn't give us an emotional response, and so we tend to just keep investing. So, I think a good target-date fund is a great thing. You need low costs and you need good funds throughout the lineup, which is not an easy thing to have; some firms may be good at one thing and not the other. So, you need all of those conditions. But if you have them, they are pretty good funds.
Benz: I completely agree with everything Russ just said. I think if the asset-management industry has had one homerun over the past couple of decades in terms of improving investor outcomes, it is the target-date fund universe. And I think when you look at which target-date series are getting the greatest asset growth, it's been the good ones. So, that's another good sign.
The think I wonder about, though, is when we look at the dollar-weighted returns, the investor returns on target-date funds, I do wonder if, as Russ said, are we just capturing the fact that 401(k) investors tend to be incredibly inert, to do dollar-cost averaging. Maybe they've been doing that all along, most 401(k) investors, we just haven't been able to really see it. Maybe target-date funds kind of give us that lens to view 401(k) participant behavior, because I think most people buying target-date funds are doing so through some sort of company retirement plan. So, I've just been kind of thinking about that. Is it that target-date funds are so great, or is it that 401(k)s and the way they force people to invest is inherently a good thing that leads to better outcomes?
Kinnel: My sense is that it's a mix because if, say, instead of a target-date fund, you had a lineup of a bunch of funds--some of which may be kind of volatile niche funds--my sense is that there are some people who historically would have taken the money out of the underperformers and put money in the hottest performers, and that leads to some pretty bad outcomes. So, I do think, to a degree, target-date funds are really enabling investors to get the most of that 401(k) and are making 401(k)s actually live up to what we had hoped they could do. So, I do think they add additional value because you can obviously make really rapid changes in today's world with your 401(k), and this kind of saves you from that mistake.
Benz: Plus, they do rebalancing for people, which is a really valuable thing. Rebalancing is one of those things that is psychologically very difficult, and it's logistically not fun to do either. If the target-date fund does the heavy lifting of rebalancing for the investor, that will tend to lead to a better long-term return.
Glaser: And what are some of our favorite target-date families?
Kinnel: Vanguard and T. Rowe Price are our favorites.
Glaser: And in a related question to this, regarding good tactical-allocation, kind of multiasset funds. If you're not looking for target-date funds necessarily but do want someone who can go anywhere, what would be some good options there?
Kinnel: Well, I mentioned PIMCO All Asset All Authority. Again, it's a contrarian play because lately it has gotten the calls a little wrong; but I do think it's an interesting bet.
Benz: BlackRock Global Allocation (MRLOX) might be another idea fund. It hasn't looked particularly good recently. People probably have to pay a sales charges if they go through an advisor, but that's another idea of a fund that we think is a good go-anywhere global fund.
Glaser: How about real estate funds, either REIT funds or something similar? What role should that play in your portfolio and what are some of our favorite options in that space?
Benz: In terms of the role in the portfolio, a lot of times I don't include a dedicated real estate allocation in a portfolio I would set up--the reason being that when you look at the performance of REITs, what we see is a very high correlation with small-cap value stocks. So, if the portfolio has some small-cap value, they are probably getting a lot of that diversification benefit that one might get with REITs. Then, as sort of a point-in-time comment, when we look at our equity analysts' valuations, I think their price/fair values for the sector have come down a little bit. But until recently, it had been a pretty expensive sector. So, I would bear that in mind. Too. REITs have had a very nice runup.
Kinnel: We have three Gold-rated REIT funds: T. Rowe Price Real Estate (TRREX); [Vanguard REIT Index (VGSIX)], which is a passive fund, and [Third Avenue Real Estate Value Investor (TVRVX)], which is a very different fund that looks beyond REITs. It looks at real estate operating companies, so it tends to move out of sync with REIT indexes. So, it's a little different animal. So, you have two really good ones on the active side, Third Avenue and T. Rowe. And then Vanguard, of course, with its low costs. It lets those REIT dividends flow through to investors. So, that's a good option, too.
Glaser: So, when you think about hidden-gem funds, maybe managers that are either overlooked or funds that maybe aren't on the top of investors' minds, what would be the hidden-gem that you'd like to unearth today?
Kinnel: I'll throw one out; Meridian Small Cap Growth (MSGAX). Meade and Schaub, who came over from Janus, run that fund. They've been running it for about year and a half. But the real reason to do it is if you look at what they did at Janus Triton and Janus Venture, you can see a really strong performance record there.
Bush: On the niche side, we talked a little bit about high yield earlier. Hotchkis & Wiley High Yield (HWHIX) is an interesting fund; it's really a bond-picker story. It's an old team from PIMCO. But they've got lot of Hotchkis & Wiley's equity analysts working with them, and they've committed to cap that fund, I think, at $5 billion. So, it's one that's interesting to look at.
Glaser: When you're thinking about recent upgrades in which the analyst staff has upgraded their view on a fund, are there any there that you think are worth servicing right now?
Bush: We did just recently upgrade Loomis Sayles Core Plus Bond (NEFRX) to Gold. So, this is Loomis Sayles; I think everybody knows Dan Fuss. This is actually not the Dan Fuss team; this is a different team at Loomis Sayles, but they're very long tenured. It's still a fund with a lot going on in terms of risk, but a little bit more conservative than Loomis Sayles Bond, for example. A long-tenured manager team, great resources, and it's a pretty nimble fund. They've been able to make a lot of calls correctly in terms of bypassing risk in 2011, which was a tough one for a lot of active bond managers. And then also, they've done pretty well in some of the riskier markets that we've seen. It's a risky fund. There is a lot of risk in that fund, but we like it a lot.
Glaser: So, if you did have to think of high-conviction funds: You'd get to make this trade but couldn't touch it for say a decade or longer; what management team or what funds do really have that kind of conviction in starting from today?
Kinnel: Well, as I often say, Primecap and Dodge & Cox are among my highest-conviction managers because you have tremendous stability, you have low costs, great process. Some of Primecap's funds are closed, so I'll mention Primecap Odyssey Growth. At Dodge & Cox, I like Dodge & Cox International (DODFX); I like Dodge & Cox Balanced (DODBX), if you want to dial down the risk. So, those are funds I would happily buy and forget about for 10 years.
Bush: On the fixed-income side, I like the Fidelity Total Bond (FEPAX) shop. Again, this is another place where it really is a team effort. They are careful about risk. It's a fund you can own and feel comfortable with for a long time.
Benz: A couple of ideas: One fund that is in my model portfolios is Vanguard Dividend Growth; Don Kilbride from Wellington Management has done a really nice job there. The overarching idea is quality dividend-paying companies and an overall quality emphasis, very low expenses. It's been a very popular fund. So, I guess if I'm watching a fund with an eye toward is asset growth potentially becoming a problem, that's something I would say I'm keeping an eye on. On the other hand, it has historically invested in very large liquid companies--which I think Russ' work in this area of asset bloat would indicate is a place where you want to be less concerned about asset size.
Another fund that I have been adding to in my IRA is Vanguard International Value (VTRIX). Not only is it a long-term holding, but I think potentially there is a little bit of a contrarian idea there, too, because it is international, but it also has a pretty healthy allocation to developing markets, which arguably are pretty cheap right now. So, those would just be a couple of names. Of course, they have ultralow costs.
Kinnel: And, of course, any low-cost broad index like a Vanguard Total Stock Market Index (VITSX) or their target-date funds. Those are also great set-it-and-forget-it funds.
Glaser: We're about out of time. But Russ, Sarah, and Christine, I really want to thank you for taking the time to talk to us today.
Kinnel: Thank you.
Benz: Thank you.
Bush: Thank you for having us
Glaser: Thank you for joining us. And just as a reminder, there will be a replay of this session available. We will email all registered users with a link to that with a transcript. I know we went through a lot of different funds today, so you'll have a chance to look at those names again and to do a little bit more research.
Please stay with us. In about 10 minutes, we'll have Josh Peters, who will be discussing the ultimate dividend playbook.
AMG Yacktman Service YACKX
Artisan International ARTIX
BlackRock Global Allocation MRLOX
Dodge & Cox Balanced DODBX
Dodge & Cox Income DODIX
Dodge & Cox International Stock DODFX
Dreyfus Appreciation DGAGX
Fidelity High Income SPHIX
Fidelity New Markets Income FNMIX
Fidelity Total Bond FTBFX
FPA Crescent FPACX
Harbor Real Return HARRX
Harding Loevner Emerging Markets HLEMX
Hotchkis & Wiley High Yield HWHIX
Jensen Quality Growth JENIX
Longleaf Partners LLPFX
Loomis Sayles Bond LSBRX
Loomis Sayles Core Plus Bond NEFRX
Meridian Small Cap Growth MSGAX
Metropolitan West Total Return Bond MWTRX
Oakmark International OAKIX
PIMCO All Asset All Authority PAUAX
PIMCO Foreign Bond (USD-Hedged) PFORX
PIMCO Real Return PRRRX
PIMCO Total Return PTTRX
PRIMECAP Odyssey Growth POGRX
Royce Special Equity RSEFX
T. Rowe Price Real Estate TRREX
Third Avenue Real Estate Value TVRVX
Tweedy, Browne Global Value TBGVX
Vanguard Dividend Growth VDIGX
Vanguard Global Minimum Volatility VMVFX
Vanguard Inflation-Protected Securities VIPSX
Vanguard International Value VTRIX
Vanguard PRIMECAP Core VPCCX
Vanguard REIT Index VGSIX
Vanguard Short-Term Inflation-Protected Securities Index VTIPX
Vanguard Total Bond Market Index VBMFX
Vanguard Total Stock Market Index VITSX