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By Christine Benz and Shannon Zimmerman | 01-13-2014 01:00 PM

Don't Give Up on These Three Funds

Sticking to their quality and valuation knitting held these funds back in the 2013 rally, but also makes them worth hanging on to.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com.

A strong stock market lifted many boats in 2013, but some funds didn't prosper as much as others. Joining me to discuss three funds with weak near-term performance that investors shouldn't give up on is Shannon Zimmerman, associate director of fund analysis with Morningstar.

Shannon, thank you so much for being here.

Shannon Zimmerman: Good to be with you.

Benz: Shannon, let's do a little bit of stage setting. You have brought a list of funds that did not perform especially well in 2013. They had weak performance for a variety of reasons, but let's discuss some commonalities. What types of funds tended not to do especially well last year?

Zimmerman: If you look at the kinds of funds that did well last year, … it was a risk-on year, so to speak. Risk attributes, like a higher debt-to-capital ratio, for instance, for the fund's portfolio that was a plus.

Benz: So more leveraged companies?

Zimmerman: Exactly right. 2009 really isn't a typical year in any context, but it did raise into relief some qualities that were on view in a smaller way in 2013. Companies that were more speculative, had riskier profiles, not only in terms of financial attributes, but just in terms of volatility, higher beta companies, performed better.

These funds, the commonality, which partly explains why they didn't do well, was that that's not the kind of company they invest in. There's a quality bias across all of them to varying degrees.

Benz: We just want to be clear before we get into these funds with weak near-term performance that we're talking relative performance. Their absolute returns have been quite strong.

Zimmerman: Exactly right--all of them above 30% on the year. So remarkable returns in terms of absolute gains. But right--in relative terms, not so much.

Benz: Let's get right into this list. At the top is Wasatch Core Growth. This is a fund that had had actually quite good returns leading up until 2013, but very poor relative returns in 2013. Let's talk about what the problem was with this fund last year, apart from the fact that maybe it emphasized quality a little more than some of its peers?

Zimmerman: It's a concentrated fund. They are exclusively bottom-up managers, and they go wherever they find the qualities that they look for. The quality bias, as with all the funds as we were saying, definitely held this fund back.

There is a higher percentage of assets at this fund that are invested in companies that have economic moats, according to Morningstar equity research, lower debt-to-capital ratios by far. But that concentration, that willingness to back up the truck, almost by accident--because they're certainly not in a top-down way saying, I want this level of exposure to this particular sector--but they go where they find prospects that they like. So, even in a good year for the fund, it can look dramatically unlike the competition, because of the way that the sector exposures skew the performance of the fund.

Benz: So, you think the fundamentals here are still quite good despite this recent hiccup in relative performance. Let's talk about what you think are strong long-term attributes for this fund.

Zimmerman: To begin with, the management team. It's a two-person management team. They've been working together as a duo for about six years, but the senior manager on the fund has been there for over a decade, and both managers have actually been with Wasatch for over a decade.

They're well steeped in that investment process, which has served the shop and its investors quite well, and it has consistently over time been a process that has guided the managers toward quality companies, lower-volatility companies as well. There's a really good track record that's been academically vetted for that kind of profile of a firm, for the share prices doing dramatically better than riskier stocks over the long haul.

But because quality doesn't always win and because the fund does have lopsided sector exposure sometimes, investors at this fund, and in all of them [mentioned today], need to be patient and live through some bumps along the way. 2013 was a bump, but the long-term track record here is phenomenal. Over the [15]-year period, the fund ranks in the 6th percentile of the small-growth category, and it's a Silver-rated fund for us as well.

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