Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Not every worthwhile mutual fund has billions of dollars in assets. Joining me to discuss some of Morningstar's favorite funds that are relatively undiscovered is Shannon Zimmerman. He is associate director of fund analysis with Morningstar.
Shannon, thank you so much for being here.
Shannon Zimmerman: Good to be with you, Christine.
Benz: Shannon, let's start by discussing the premise here. Why do you even want to take a look at funds that have relatively smaller asset bases? What's the advantage of doing that?
Zimmerman: Well, so, particularly among small-cap funds, the managers are able to be more nimble in terms of entering and exiting positions. When you think of a small-cap manager trying to build a position in a small-cap company, what's going to happen, if they have a ton of assets, as they are moving into a name, is they're going to move a stock against the fund. They are going to raise prices as they build that position with a lot of money, and as they exit the position, they are going to push the price down because they are withdrawing a lot of money. A small-cap manager with a reasonably sized asset base is able to enter and exit a position, largely at will, without fear of moving the stock price against the fund.
Benz: So, the big advantage is for smaller funds, or funds that invest in less liquid assets, where that's potentially an issue?
Zimmerman: Exactly. Yeah. That's what we are talking about when we use the term asset bloat, one of my favorite fund analysis terms, that's what we mean, when the fund gets too big for moving imminently in and out the kinds of names that it likes for the very reasons that you cite.
Benz: So, let's talk about how the analyst team approaches ratings for these funds that you cover. You have a medal system that you look at. Let's talk about what it takes to garner one of those high Analyst Ratings, either Gold, Silver, or Bronze?
Zimmerman: Sure. We have five ratings; there is Gold, Silver, Bronze, Neutral, and Negative. And to garner a medal is a big thing, even if it is a Bronze medal. That's an endorsing notice on the part of the analyst because that expresses the analyst's belief that over the course of the next market cycle of at least five years, the analyst believes that that fund--Bronze, Silver, or Gold--will be able to beat the typical fund in its category. So, that's a pretty high level of conviction.
From there we look at five analytical pillars. There is People, Process, Parent, Price, and Performance, and we rate each of those independently, though when you get right down to it, of course, there is cross-pollination across those pillars because one informs the other. But we rate each of those as discrete areas, and then those roll up to an overall Analyst Rating. So the ones that we award medals to are the ones that we have the highest conviction in--Bronze, Silver, or Gold. The funds that we are going to talk about today have all garnered nice Analyst Ratings--Silver in two cases, Bronze in one, and not a lot of assets, which is somewhat surprising.
Benz: In contrast with the Morningstar Rating for funds, which is backward-looking and looking at the risk/reward profile, you are really trying to be forward-looking here?
Zimmerman: That's right. What we like to say is that the Analyst Rating is an aptitude test: What is the fund capable of? Whereas the star rating is achievement test: What has the fund done?
Benz: Let's get right on into some of these hidden-gem funds. One of the first ones is a small-cap growth fund. It's Conestoga Small Cap. Let's talk about why the team likes that fund?Read Full Transcript
Zimmerman: So, this is Silver-rated fund with about $350 million in assets, which is quite small. Even for a small-cap fund, it's quite small. It's a Silver-rated fund. It has over the last five years an annualized gain of about 8.2%. It landed in the top quintile of the category and has done quite well. But it still hasn't garnered a ton of assets. We like it because it focuses on higher-quality names that have track records of sustained profitability. This is the small-cap growth [category], which can be a very volatile part of the market and nonetheless part of the market that many investors want to have exposure to. So, personally as an investor, that's the kind of fund I gravitate to in that space. And so what they do to have a hurdle for the kinds of companies to get into the portfolio is to focus on profitability in the form of return on equity, which is a good measure of a company's profitability, whereas the Russell 2000 Growth Index, which is this fund's benchmark, has about 13% ROE right now. The fund's is about 17%, not a huge differential.
Benz: So, that's return on equity?
Zimmerman: Exactly, right. Again, a measure of profitability.
Zimmerman: Not a huge differential, but big enough that it matters and so the fund has a much higher quality tool and the overall Russell 2000 Growth. Performance has been strong. The managers have been at the helm since inception, and it's one of the funds that we like even though it hasn't garnered a lot of assets. And given what we were saying before, that can make it an interesting fund to look at, too, since it has all the other pillar powers in place.
Benz: Right. So, it also seems when a fund is small like this and it's focusing on small-company stocks, it probably is a good indication that it can stick with small caps, so the manager won't have to graduate up and start buying Apple anytime soon. It actually can stick with the smaller companies?
Zimmerman: Excellent point because a lot of folks want to be their own asset allocator. They don't want the fund to drift away from the area of the market where the managers have proven themselves and that the person who is coming into the fund who wants to have exposure to. A lot of times, to contend with asset bloat, companies rather than tightening the inflows, they say, "No, we want to continue to get the flows," because it helps them to garner more fees. And they'll go up the market-cap ladder to accommodate more money when really that's not the manager's forte.
Benz: Right. The next fund that you want to talk about is a more value-leaning fund that lands in our small-blend category, but it does focus on small companies also. Let's talk about Berwyn Fund.
Zimmerman: Berwyn Fund. It does have that value orientation, about $360 million in assets, and about $250 million in assets outside of the fund in separately managed accounts that are run according to the same strategy, but still quite small for a fund. This is also a Silver-rated fund. It's in the small-blend category. It moved out of the small-value category, not because the managers have changed their stripes or are pursuing a different kind of strategy, but really because that's where they are finding the bargains. The fund does have a quality tilt right now, but the value piece of it trumps the quality bias.
Interestingly--and I think this will strike some folks who think this is a value fund and maybe it has drifted into blend territory--technology is not typically a value haunt for portfolio managers, but in this fund's case, it's a substantial overweight, about 20 percentage points overweight, versus the small-blend norm, in technology stocks right now. That's not because again, they've changed their stripes or pursuing a different strategy, but because they like healthy balance sheets right now, relative to the company's prospects and certainly relative to the multiples.
Benz: I like, Shannon, that you mentioned how much in other nonmutual fund assets these managers run. I'm guessing you would say that that's an important of investors' due diligence process. Don't just say "These funds are small, ergo these managers are nimble." Sometimes that's not the case.
Zimmerman: That's exactly right. So in fund assets, typically when people think about the size of a fund then they're thinking about the fund's assets. But typically the SAI will list how much they manage in assets beyond the mutual fund, and you don't always know are they managing those assets in the same strategy. But for small companies like this, it's sort of a safe assumption. Of course you can always get on the phone and call them up or head to the Morningstar Analyst Report to find out more information about where the managers are managing money.
Benz: When you say SAI, that's Statement of Additional Information?
Zimmerman: Yes. The most boring name and most exciting document, where you can also find how much managers are invested in their funds, too.
Benz: So the last fund you want to talk about is not a small-cap fund, but it's nonetheless one that you think investors looking for quality large-cap exposure should take a look at.
Zimmerman: That's right. It's one that I cover. It's John Hancock U.S. Global Leaders Growth. I think that it's probably the best large-cap fund that John Hancock has right now. Assets are under $1 billion in the fund. Now the subadvisor behind the fund, that actually manages the money, they manage billions of dollars in this strategy outside of the fund. But the fund is still quite small for a large-cap fund, about $890 million right now, so under $1 billion. It's a concentrated fund, about 25-30 names typically in the portfolio. But given the area of the market that it focuses on, large-cap growth stocks, liquidity is not really an issue. So there's no capacity constraints here to worry about.
Over the long haul, [the shop, Sustainable Growth Advisors,] has a tremendous track record. They do just this one strategy. They do this domestic flavor and then there's an international fund that isn't run for John Hancock. They run its house brand, I guess you could say. Tremendous track record. One thing that I'll note about this fund is that it did well in both 2008 and 2009. I think for investors who are trying to begin to research a fund, it's always interesting to see what funds did during those two years. Typically funds that did well in 2008, didn't do so well in 2009 because…
Benz: They are more defensive.
Zimmerman: Exactly, [in 2008 and 2009 it was] sort of a mirror image of markets. This fund did well in both. And talking with the managers there and then doing my own sort of Colombo work, why is that the case? It turns out that they have a high-quality bias, looking for companies that throw off plenty of free cash flow in a sustainable, consistent way. But it was the concentration of the fund that amplified returns in 2009, and it was the quality nature of the fund that served it so well in 2008. So it's a strong fund, like I said, probably the best large-cap fund that John Hancock has in its lineup right now. Why is it only Bronze? It's Bronze because the price is little too high and moving in the wrong direction. So if the fund assets grow, presumably that price tag will come down. But right now it's about 1.3% for its expense ratio, which is pretty pricey for a large-cap fund.
Benz: One thing we've seen is that investors seem to have been strongly gravitating to index products and ETFs in that large-cap space. What's the case for investing in an actively managed fund in the large-cap space?
Zimmerman: That's an excellent question. This is a question I keep asking my managers, as well, because you look at these large-cap companies, they're household names. Why are they covered? What cannot be known about them? And it all comes down to I think in most cases valuation work: Are you buying them well? It's hard to buy Johnson & Johnson well; it's hard to buy Apple well, right? But some shops have a tremendous track record of doing just that and other shops don't. So it's possible to do it, but it's very hard. It's harder by far than in the mid-cap and small-cap arenas to succeed in an actively managed fund when so much is known about the companies that are in the portfolio.
Benz: So selectively really matters.
Zimmerman: It definitely does.
Benz: Shannon, thank you so much for being here.
Zimmerman: My pleasure.
Benz: Thanks for watching. I'm Christine Benz from Morningstar.com.