Wed, 7 Mar 2012
Investors in international equities have been rewarded nicely so far in 2012, but questions abound as to whether they're putting money into overvalued names, says Morningstar's Shannon Zimmerman.
Christine Benz: Hi. I'm Christine Benz for Morningstar. After embracing risk earlier this year, investors appear to be in risk-off mode recently. Here to discuss some of the latest trends in mutual fund performance is Shannon Zimmerman, associate director of fund analysis with Morningstar.
Shannon, thank you so much for being here.
Shannon Zimmerman: Thank you for having me, Christine.
Benz: So, Shannon, you said that it's kind of a tale of two markets. It started with investors really embracing the aggressive stuff, which was very economically sensitive and performed well. But that's less so recently. Let's start with what worked well in the January period and what has worked better recently.
Zimmerman: I think, it's a good way of characterizing it: a tale of two markets. Obviously, the year-to-date period is quite short, and certainly a month is quite short. But what happened over the last four weeks relative to what's happened in the year-to-date period is quite starkly different. The things that did terrific in the first part of the year, didn't fare so well in February. You don't want to read too much into a short period of time. But for instance, financials which did quite well in January, didn't do very well at all in February in terms of the mutual fund categories that target those areas. I don't know that I would characterize it as a lurch toward risk or a lurch away from risk, but certainly the markets continue to be volatile. The crisis in Europe continues to unfold, and it's not a surprise to me that as we've seen over the last seven or eight years, the net flows into U.S. stock funds are in net redemption mode. They are dried up, whereas on the bond side, flows have been torrential to very strong. That persisted in January, I wouldn't be surprised to see February do more or less something along those lines.
Benz: Investors continue to pull from stock funds?
Benz: So when you look at year-to-date performance, however, it seems that the rally was so strong in the first part of the year that if you did have some of those asset classes, such as financials or technology stocks, you're still ahead than if you had been in a very risk-averse portfolio?
Zimmerman: Absolutely. On a year-to-date basis, it absolutely has paid to have a riskier, more economically sensitive portfolio. Technology stocks have fared quite well; financials have done remarkably well after taking a drubbing in recent times. It is not a surprise to me just on the level of valuations to see the areas of the market that have been so beaten down, bounce back. We've seen that over the history of many, many market cycles, it pays to be contrarian and to love the unloved, so to speak. So that snapback seems to have been under way.
Whether or not it will persist, probably has to do with a couple of things. From an investor's point of view, whether or not the people are focused on the macro economy, they know what the news is on a nightly basis. For instance, unemployment is getting better, but it's still quite high. Investors are yanking money out of U.S. stock funds consistently. The jury's still out on whether the activity we saw in the beginning of the year will continue.
Benz: So, Shannon, a big thing affecting global markets obviously has been what's been going on in Europe, and we did see a little bit of a snapback, year to date at least, for international equities. What are the key themes, and what have been the big beneficiaries of that snapback recently?
Zimmerman: The managers that I follow are all, to a person, pretty much bottom-up fundamental stock-pickers, and so they are not making moves into regions. David Herro at Oakmark International in particular is a really good example. Just as he did last year in the aftermath of the tsunami and earthquake in Japan, he dialed up his exposure to that part of the globe, primarily through the companies that he already held. In his view, of course, it was a catastrophe and tragic occurrence, but in terms of the companies that he held, their valuations became more attractive overnight for reasons that weren't related to fundamentals at all. He is a fundamental investor, and so for him that created opportunities to buy more shares of the companies that he had liked in advance of the tragedy, anyway.
Similarly, if you look at his portfolio, now Oakmark International has about 70% in Western Europe, and you take out the United Kingdom and look at the part of Europe that's leftover in the portfolio, he's actually overweighted relative to both what it was last year at the end of the year and relative to the fund's history. It's about 59% now, and on average it's been 53% during the last five years. So, he's dialed up in a meaningful way, not in a huge way, but he's still showing that sort of contrarian impulse to find opportunities where other people aren't even looking.
Benz: And that has been relatively beneficial year to date?
Benz: Emerging markets, too, have enjoyed a very strong snapback after being some of the worst-performing funds last year. What have been the big drivers there?
Zimmerman: Well, among emerging markets, I think, it's again a tale of two markets. It's a tale of two investor types as well. So, yes, emerging markets have been the hot properties of international mutual funds for some time now. But a lot of the fund managers that I speak to, who don't traffic heavily in that part of the world but do traffic somewhat, continue to see emerging markets as somewhat overvalued. When you see three years of pretty strong performance coming out of that region, that's not a surprise to me either. So, if you are contrarian, if you are an absolute-value stock-picker--and so you are less concerned about macroeconomics and regional overlays than you are with the individual fundamentals of particular companies, well, a David Herro type--then that really does create an incentive to move maybe away from the emerging markets that you continue to view as being overvalued because of the performance in recent times. And then you move into the areas where it looks kind of sketchy, but on a company-by-company basis it does not.
Benz: So the fact that emerging markets dropped a lot in 2011 did not mean that the true value managers necessarily saw a buying opportunity there?
Zimmerman: I think that that is largely true. It's almost like 2009, but it's sort of like targeting a region rather than a calendar year. In 2009, the runup was in some ways consistent with the market history in anticipation of a recovery; the riskiest fare tends to do best out of the gates. But still to me there's an open question as to whether or not what happened in 2009 and what's happened subsequent to that has left the markets fairly valued or maybe even slightly overvalued. Certainly among absolute-value investors, not to a person, but on average the sense that emerging markets remain overvalued persists.
Benz: Now, I just want to shift gears a little bit to fixed income. The trends that we've been discussing--where some of the risky stuff was really rallying early on, but has sold off a little bit recently--has that carried over to fixed income, as well?
Zimmerman: It has, but not as dramatically, so if you look at the domestic-stock categories, I think, 16 of 21 categories declined in February, whereas all but one were up in January. That dynamic is not as across-the-board in the high yield or in the fixed income world, but yes people have sort of stepped back. It's interesting to see a long-term bond category doing quite well. Why is that? I think it's the wild goose chase for yield. Investors have to go some place, and it's not that the yields are so tremendously attractive. I was looking at the 30-year T-bill before we began our conversation now, and it pays about 3% I think, that's better than 2%.
Benz: Or zero.
Zimmerman: Yes, right. So, people are going some place for yield, and so even though that's a paltry figure, the one fund that we like in that category is actually up 12% because, as with all investments, people need to keep their eyes on the total-return prize. So, if you have a nice yield, but price erosion takes back what the yield gives, then you're really not earning anything.
Benz: We've discussed year-to-date statistics so far, but that's obviously a very short time frame. I'd like to dial it back a little bit. March 9 marked the three-year anniversary of this market recovery that we've all experienced. And I'm wondering if you can kind of opine first about what has really performed best, and also how investors should be viewing their funds' performance tracks given that we have had this tremendous snapback?
Zimmerman: Right. That to me is the critical point for investors now. It's a teachable moment or just a moment for reflection. So, three years ago, March 9 was the nadir of the market, and then we had the fast-and-furious rally that happened in 2009. Things have been choppier since then but still on an upward trajectory. But the important thing for fund investors in particular looking at trailing-period returns is that they're better than calendar-year returns, which are certainly just a small arbitrary block of time. But trailing-period returns are also arbitrary periods of time, and now we are about to experience that first-hand because after March 9, here comes March 10. And that three-year record that previously reflected the debacle is now going to be swept under the rug for the three-year return.
So, I think, in a lot of cases, folks will see a big gap between the three-year trailing return of the funds they hold and the five-year trailing return. And for people who are maybe prospective investors in the fund, that might be alarming or surprising, but it shouldn't be. However, it should cause them to want to dive a little deeper to understand the numbers. For example, the three-year number looks good now. But what happened in 2008 and into the early months of 2009, and does that tell me anything about the performance of the fund going forward? Because with the same management team, it probably does.
Benz: So, my guess is that for a lot of funds, you'll see really different relative-return rankings for those two periods. I guess that would tell you a little something about the character of the fund. So, a good five-year performance but a lousy three-year performance might indicate a fund has a little bit better down-market protection.
Zimmerman: Exactly. In some ways, as painful as it was to live through that experience, it's interesting to see that 2008 and 2009 happened in such quick succession because that really tells you a lot about a fund just based on the way that it performed.
Benz: Those two years.
Zimmerman: Yes. So you would anticipate, and it's mostly the case, that the funds that did the best in 2008 wouldn't have been among the highfliers in 2009. However, there are a handful of funds that did well in both years. And those are the funds that really warrant a lot of scrutiny, I think, and you can sort of see at least in my research into that area, certain funds tend to have that profile--funds that did relatively well both in 2008 and 2009.
Benz: Yacktman is one, I know that.
Zimmerman: Yacktman, yes. John Hancock U.S. Global Leaders Growth is one, too, with a very concentrated portfolio, concentrated on quality stocks. Well, quality stocks shouldn't have served it well in 2009, if you look at performance attribution; they didn't. But the concentration certainly did serve the fund well because the managers invest exclusively in their best ideas. So they were able to amplify the returns by having relatively few names; I think, 25 to 30 names are typically in that fund. It is a high-quality portfolio that did well in 2008, as you would anticipate, but also in 2009.
Benz: Well, Shannon, thank you for this recap. It's always good to kind of step back and think about what's driving fund performance. We appreciate you being here.
Zimmerman: My pleasure.
Benz: Thanks for watching. I am Christine Benz from Morningstar.com.