Thu, 25 Jul 2013
Morningstar's John Rekenthaler offers his take on whether market hot spots, such as low-volatility funds, alternatives, and multi-asset-class income vehicles, have long-term staying power.
Christine Benz: Hi. I'm Christine Benz for Morningstar.com. Much like the apparel industry, the investment industry is often quick to hop aboard the latest trend. Joining me to talk about some of the latest trends is John Rekenthaler. He is the vice president of research for Morningstar.
John, thank you so much for being here.
John Rekenthaler: Indeed, Christine, pleasure.
Benz: John, let's start with a category where we've seen a lot of investor interest. We've seen a lot of new exchange-traded funds launched to capitalize on the trend, and the idea is low-volatility stock investing. I'd like to get your take on whether you think this is a fad, a gimmick, or whether it's an investment trend that actually has staying power.
Rekenthaler: First, just before we go, because we're going to talk about a few of them, these are my views, but I think it can come across a little bit too glib like a movie critic, thumbs up, thumbs down. I'm going to be wrong on some of these. These are just my views. When I hear, this is based on past experience, but I will be wrong on one or two. I want to go at this with a little bit of humility because it sounds like I'm going to have views on everything. Because I have views doesn't mean I'm right on everything.
Anyway, so if we start with low volatility, I'm suspicious of low-volatility funds because I remember something actually somewhat similar 20 years ago in the early 1990s. Utility funds and other low-volatility funds at the time had the best 10-year track records. They were not only the lowest in volatility. They had the highest returns. They were hogging the Morningstar 5-star ratings as well as any other risk-adjusted returns, and a lot of money flowed into them. And they got whacked in 1994 when interest rates rose.
Benz: The data look really good when you look at these low-volatility strategies, too, that the returns are better than higher-volatility strategies and, of course, risk is lower.
Rekenthaler: Right. The good news about these strategies is there is actually a fair amount of academic research behind them and some good people and some good firms, and they also have an economic argument as to why low-volatility strategies should outperform. It has to do with institutional constraints on leverage and so forth. So it's not just data mining. I mean, there is also an economic explanation that has some good parties at this table. The timing feels bad to me. It feels like 20 years later. Interest had been dropping for a decade. That benefits these low-volatility investments which tend to be interest-rate-sensitive, and they got whacked when rates rose. Now we've had a 30-year period basically where rates have come down and maybe they're starting to rise, and guess what, these strategies are being promoted. So the timing feels wrong to me. I think this is not the time I would be enthusiastic about them.
Benz: Let's just walk through why would a low-volatility strategy necessarily be hurt in a rising-rate environment?
Rekenthaler: Well, these things tend to have higher-dividend, slower-growing companies, mature companies, so they act more like bonds. It's less of a growth story. In some cases, when you get into the traditional utilities, they really are surrogate bonds.
Benz: Speaking in terms of income-producing investments, there has been a mania for anything kicking off income recently. One category that we've seen launch recently has been this group of multi-asset-class income-producing vehicles. I tend to be a little bit skeptical because here, as you say, we've got very low yields and yet a lot of product launches. What do you think about that category?
Rekenthaler: I like the general notion of it. I'm a fan multiasset classes to diversifying risks rather than a narrow and specialized [approach]. There are so many narrow and specialized funds these days , as we know with exchange-traded fund launches. And we know from the history of sector funds, that people tend not to use specialized funds very well. They're quite volatile, and investors tend to buy in after the good news is out sell them [after the bad news]. It leads to a lot of bad habits. I like these more diversified, almost solution-type, funds. I like it in concept.
It would depend on the fund. You've got to keep your costs low. Because these can be high-concept funds, they are also high-priced funds. In which case, no, I don't like it then. Also, sometimes they are sold as high-concept, high-turnover trading type funds. And those [I don't like] so well. But I like the idea of it. I think that there probably will be some good multi-asset-class income funds created and I would look at them if I were interested in getting income on my portfolio.
Benz: Certainly when you look at our data on investor returns, you see that the more stuff you bury under the hood of a single vehicle the better investors tend to do with it, as you said. John, I'd like to talk about some of the new dividend-focused funds; a lot of them with a foreign flavor. We've seen emerging-markets dividend funds launch as well as broader global dividend-focused products. Your thinking there?
Rekenthaler: I suppose it's along the lines of what we've talked about. So far the timing seems off, with people looking for dividends and income at a time when yields have come down, and a lot of the performance of those kind of securities has been good. Dividend stocks are [at similar levels to] where we were three or four years ago. I suspect a lot of these are a fad, in the sense that they won't do very well over the next three to five years on a relative basis and the funds won't exist anymore because when you launch a fund and if it performs poorly for three to five years, there's a good chance it's not around [after that time]. I'm not wildly against the notion, but I think the timing is off. It also sounds a little narrow and specialized.
Benz: It seems like if you have a firm that has maybe some skill-set in investing in global dividend payers and has done so for a period of time, I'm thinking of like the Tweedy Browne fund that focuses on dividend payers globally. That seems like a reasonable idea.
Rekenthaler: If it fits naturally and organically within a company's investment strategy [then it is a good idea]. But as an asset class, as a type of fund you need to own in a portfolio, I don't think so. I think I would, as you say, buy it if the investment manager happens to be attractive and it's a firm that you're looking at doing business with anyway. Then maybe it fits.
Benz: How about tactical asset allocators? That's another category where we saw a lot of interest several years ago, and then again more recently coming out of the bear market we saw tactical asset allocation getting a lot of interest again. Do you think such funds make sense when you look at their total performance? How have those funds done over time, and do they merit a role in investors' portfolios?
Rekenthaler: I think these funds clearly have the letters FAD written on their foreheads, more than anything else that we've talked about. Frankly, these things just come out exactly at the wrong time, and they disappear. They came out circa 1990 after the 1987 bear market crash. People want to get tactical after they lose money in a crash. They come out and are marketed that you can dodge the next downturn. Of course, there isn't a downturn for a while because the prices are cheap because you just had a stock crash. It's the wrong time to be in them. And they were gone by the mid-1990s. This is again a second round. I've seen this twice now: the tactical asset-allocation funds that come out in the late '80s and the tactical asset-allocation funds that came out in 2008. And they tend not to be cheap. They tend to be launched at the wrong time. And when you need them for the next crash, they won't be around.
Benz: Let's talk about a very broad basket that has received a lot of interest over the past decade really. This is the whole category of alternative investments, and I think there are some differences of opinion about what even constitutes an alternative. But what's your take on alternative investments and their roles in retail investors' portfolios?
Rekenthaler: I like alternative investments, again, as part of a solution. I like the fact that target-date funds or maybe these multi-asset-class income funds, broader-based funds will bring in some alternatives.
Benz: Meaning what, like what type of alternatives would be sensible, like the commodities?
Rekenthaler: Commodities could be [an example], a small piece of commodities. Some of these funds might even incorporate some sort of long-short strategy, though that's less common. But that would be fine. I think those work. They've not been particularly successful as stand-alone bits like managed futures. Managed futures funds have been out for half a dozen years or so now in any kind of real way in sort of the retail fund industry, and people have bought them at just the wrong time. They bought them right after they did well and then they sold them as they did poorly and so forth. Again, they're specialized, they have unpredictable behavior, and from a perspective of investor returns, it's not very good.
Also a lot of these are expensive too when you buy them stand-alone. A lot of these market-neutral funds will have a 1.5% or 2% expense ratio. Well, a market-neutral fund by definition is a low-volatility, lower-expected-return fund. When you have a lower-expected-return fund with 1.5% or 2% expense ratio, it's pretty hard for that to be good. As part of a cheaper, broad-solution fund that a professional or institutional investor is running, they're good. They're helpful. They have a lot of good characteristics for diversifying a portfolio. There are reasons why, and you see papers that show why alternatives help to make portfolios stronger. Morningstar has written some of these papers, as well. They're good if applied that way. They haven't been used very well, and are rather, I think, not great products overall as stand-alone funds.
Benz: Certainly when you look at performance among funds in our alternatives category, you don't see a very encouraging picture when you look at those that have been around for five years or more.
Rekenthaler: Again, I think it's not a perfect comparison, but the comparison to the sector funds is a good one. There've been a lot of sector funds, and they have been a major part of the fund industry in that sense sits well before I started at Morningstar 25 years ago. And sector funds have never really been helpful for people, I mean, throughout the decades. And there is a reason why they are a very small portion in terms of assets. There are a lot of funds, but not much money there because they haven't made money for people.
Benz: John, we've talked about a lot of investment trends that you're a little bit lukewarm on. What have been the truly great innovations in the fund industry over the past, say, couple of decades?
Rekenthaler: Well, I'm going to go back longer because I think the great innovation in the fund industry has clearly been the index fund. I mean, just when you look at where the assets are now and the growth in exchange traded funds as well as mutual funds, the marketplace is saying the index fund was a major revolution.
Benz: Given these very low-cost products.
Rekenthaler: Yes, it's really about the cost side and driving the costs down. As I've argued many times and shown many times, it's not that performance of active managers setting aside costs is worse in aggregate than an index or a low-cost index fund. And [Vanguard founder] John Bogle has said, the key to a low-cost index fund is the low-cost part. That has been the innovation in the fund industry; that's a 40-year-old innovation.
A couple of other items that I would highlight would be solutions funds such as target-date funds. Target-date funds have had their critics, but they've done a great service for 401(k) participants by getting them into a broad-based single solution as opposed to having them try to be investment experts. The everyday employee doesn't want to [be interested in investments]. You might be interested in investment; I might be interested in investments. I hope the audience is, but not everybody is. And that's unrealistic to expect that. A target-date fund is an excellent solution for those people in general solutions funds.
And the final category I'd mention, and what I hope maybe some of these multi-asset-class income funds become is, I guess, what I call the broad-based fund that crosses over asset-class borders. PIMCO Total Return is a fund that was different than other bond funds when it came out. It wasn't just a government-bond fund. It wasn't just a corporate fund. It wasn't just a mortgage fund. It combined those.
Benz: It's free-ranging.
Rekenthaler: It was free-ranging, but free-ranging not in a gimmicky way, not in "We do tactical, we have all these great models, and we're going to go here and here and here." It was just more bottom-up. They're always going to have a mix of things, but what seems to be the better of the values. And they're not charging up for the flexibility. It's a competitively priced fund. I like these funds that have the barriers knocked down and that are able to do more things without being marketed as global and tactical because that ends up costing more. When you add that marketing, then there is a price to pay for it. Give me a fund that costs the same as the other funds but does more things.
Benz: Right, John, thank you so much for being here. It's always great to hear your insights on these trends.
Rekenthaler: Always great to be here with you, Christine. Thanks.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.