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By Jeremy Glaser and Shannon Zimmerman | 04-03-2013 04:00 PM

The Changing Investing Landscape

Morningstar’s Shannon Zimmerman discusses the rise of passive investing, changes in the fixed-income environment, the search for yield and the lasting impact of Jack Bogle’s 2002 conference keynote.

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Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. The Morningstar Investment Conference is celebrating its Silver Anniversary this year. There've been some pretty big changes in the investing landscape over the last quarter century, and I'm here today with Shannon Zimmerman, associate director of fund analysis, to look at some of those trends and what investors can expect to hear at this year's conference. Shannon, thanks for joining me today.

Shannon Zimmerman: Good to be with you, Jeremy.

Glaser: So, it's been a long time since our conference has started, but let's look at some of the big trends. One has to be the rise of passive investing. Over the last 25 years we've seen index funds and exchange-traded funds really take a lot of market share, a lot of mindshare. What's the state of active investing now, and what do you expect to hear about it at the conference in June?

Zimmerman: Well, there are proponents on both sides of that debate, of course, and they are rather vocal about their views in terms of the advantages of each approach to investing. My own personal view as an investor, as an analyst here at Morningstar, is that passive investing and active investing, these are just different strategies. A strategy isn't going to succeed in every market, so you don't have to make it an either/or proposition. You can have exposure to both index funds and those that are actively managed. But a lot of folks don't see it that way.

In terms of the state of passive investing versus active investing, if you look at flows, passive has had it all over active investing for some time now. And I think that that owes in some ways to the fact that 2008 happened, and people who had sort of trusted active management to help them dodge bullets essentially, well, that didn't happen. Everybody kind of got spanked. Indexes fell of too, but with an index fund, at least you know you're getting the market exposure.

Glaser: What's been happening in terms of active managers, though? Have they been kind of mimicking indexing or have they really just been holding the market? Or are we seeing those active managers trying to be a little bit more selective in their security selection?

Zimmerman: Well, it's some of each, I guess. The better managers do try to be more selective in their security selection, and they understand that the way they have an opportunity to outperform is to differentiate their fund, their portfolio from that of the index. If you're just going to be an index-hugger, then eventually investors are going to find that out through the research reports that Morningstar fund analysts write, if nothing else, and move away from those actively managed funds that are really index-huggers because typically they are overpriced relative to what you can get for an index.

Some of my favorite funds are those that have a high active share, and that's a relatively new statistic. It's sort of like the measurement R-squared, where you can look at the correlation of a fund's performance relative to an index. So, whereas R-squared tells you how much of a fund's performance can be explained by movements in a given index, active share tells you how much overlap at the security level and at the level of position size a fund has with its index. Higher active share means that the fund deviates from the index more, and that's where you have a better opportunity to outperform. But, of course, the reverse is true, too; you have a better opportunity to underperform that index because you're moving away from it.

Glaser: So has active share been a hot topic of conversation?

Zimmerman: It has certainly on investors' minds, and then also among managers. But really, the managers that I like best and that we tend to like best in Morningstar's fund research group are those that have always sort of focused, whether it was called active share or not, on deviating from the index in order to outperform that index. Remember Charlie Dreifus of Royce Special Equity. I interviewed him many years ago, and he said that if he had a flag outside his office, it would say tracking error is good. For the best managers tracking error is good because usually the tracking error indicates they are outperforming the index rather than underperforming it. High tracking error is fine if it’s the upside.

Glaser: Anotherarea that's seen big changes over the last 25 years is fixed income. We went from a period of lower interest rates or declining interest rates and low inflation, some really big tailwinds that helped the fixed-income sector, but now rates are fairly low. I mean, maybe we're not totally done with that process yet, but for the most part there's an expectation that the next 25 years might not be so rosy for fixed income. What other changes have we seen in that space, and what are some of the big topics you think are going to be on investors' minds in June?

Zimmerman: To your first point, you're right. It does seem like there's only down to go, given where yields are right now for many fixed-income investments, but we've been saying that for years. You have wonder, well, at some point you say, "Well, either we were wrong, or we're just not right yet." Sometimes in investing, being right too soon is the same thing as being wrong. So I don't know. I mean, you look at the flows into bond funds, and for a long time I think pundits were misreading the flows data, at least a portion of it, because folks were assuming, "Oh, well, investors were fleeing risk." So they were moving out of equity funds. And money was coming out of equity funds in droves. That situation hasn’t completely corrected, but it's much better now than it was a year ago, or certainly two years ago.

But about a third of those flows that were going into bond funds weren’t coming out of equity funds. They were coming out of money market funds, in that mad pursuit for income during a period where it was very difficult to find income. So I think that in part it was a misread. Investors aren't necessarily risk-averse right now when it's so hard to find income. They are kind of upping their risk profile at least on the margins because they are moving money out of money market accounts and into bond funds. That's a move toward risk.

Glaser: How about investors looking for yield more generally? We've seen a huge surge of interest in dividend-paying stocks, master limited partnerships, and in other types of securities that give a little bit more income over the last couple of years, particularly compared with maybe when the conference started [25 years ago], as it's become more difficult. What do you see on the search for yield? Is this kind of a misguided quest?

Zimmerman: Well, one of my colleagues, Dan Culloton, is going to lead a panel [at the conference] that’s focused on this question of dividend-paying stocks, and whether or not there's a dividend bubble right now. That's been a hot topic for a while. Investors have been pursuing yield wherever they can find it. I remember [PIMCO manager] Bill Gross at the Morningstar conference a couple of years ago said something that was just remarkable, given his role as sort of the bond kingpin, that relative to fixed-income investments, whose yields were so remarkably low, dividend-paying stocks were looking better and better to him. I think that continues to be true today.

The question of whether or not there has been a bubble in those kinds of stocks is an important one because maybe you can find a company that pays a yield that's comparable or better to what you might have found 10 years ago or so on a fixed-income investment.

But if that company stock is overvalued and tumbles when the market tumbles, the price erosion takes back what the yield gives, and then investors really aren't earning anything at all. So I think that Dan's panel will probably be a hot topic. As with the indexing versus active management debate, there will proponents on both sides of that question.

Glaser: [Vanguard founder]Jack Bogle will be having a conversation with Morningstar's Don Phillips during the conference. What stuck with you from some of his past appearances, and what would you expect him to touch on this year?

Zimmerman: Well, one speech that he gave in [2002] as a keynoter at the Morningstar Investment Conference that year has really stuck with me. In fact, of all the investment conferences I've attended and the keynoters that I've had the privilege to hear speak, it's probably the most important speech that I think I've ever heard at an investment conference. It was called "The Telltale Chart," and if folks want to read the text of that, they can go to the Bogle Research Center and the text of it is there. Again, the speech is called 'The Telltale Chart.'

Bogle is a mean reversionist. So everything sort of seems trendy to him, including two factors that are vaunted and really have a lot of buy-in in the investment community in terms of being providing permanent premiums, the small-cap premium and the value premium. Many sophisticated investors believe that, by and large, small-cap stocks will outperform large-cap stocks over the long haul, and the value stocks will outperform growth over the long haul. That may be perfectly true. But what Bogle shows in this speech is that over a very lengthy time series, at that point it was [74 years], you remove relatively small slices of that time series and the whole premium for small cap and most of the premium for value simply goes away.

So if people attach such significance to the small-cap premium and the value premium, shouldn’t it be supported by more than just a few years in a very lengthy time series? You would think so, but Bogle's point is we look at market returns in an aggregate way that really obscures what's happening if you, sort of, get under the hood and find out what the movements have been more discretely over time.

Glaser: So are there any other speakers that you're particularly looking forward to?

Zimmerman: Well, I'm leading a panel with Bill Nygren of Oakmark and Steve Wymer of Fidelity. So Bill Nygren is a value investor, but a nontraditionalist in a way. In fact, Oakmark has seven funds, and for a while there three or maybe four of them actually had portfolios that landed not on the value column of the Morningstar Style Box, and not even the blend column. [They landed in the] growth column. They were growth portfolios. And I was getting emails from some folks who were investors in those Oakmark funds, saying "What on earth is going on? Why do they own Google and Apple? That's not a value stock." Nygren and all of his colleagues at Oakmark don't think about value in the traditional sense at all. They just want to see a big gap between what the market has priced the company at and what they believe it's actually worth. If it's a tech company or if it's a biotech company, wherever it is, if there is a gap--and they want to see a gap of about 40% between their estimate of intrinsic value and a company's current share price--they will invest.

Steve Wymer, on the other hand, is just a classic growth investor and always has been, and somebody, like Nygren, who has high active share. His benchmark is the Russell 3000 Growth at Fidelity Growth Company, which is the fund that he has had such success with over the course of many, many years. Its market cap is remarkably small compared with the index and compared to the category, as well. So he really goes his own way, and he has had a lot of success with that.

So it will be interesting to see investors, at least in Nygren's case, not a pure traditionalist value investor at all, but somebody who comes to investing from that value perspective, and Steve Wymer who is really a growth purist. It will be an interesting conversation, I think. The main topic I want to get them to address is, what has been the value of active share for them or deviating from their indexes, and as maybe these days, is it the case that growth versus value is really a distinction without a difference.

Glaser: Well, Shannon, thanks for your preview today.

Zimmerman: Good to be with you, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser.

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