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Rekenthaler on Five Fund Phenomena

Jason Stipp

Jason Stipp: I am Jason Stipp for Morningstar and welcome to The Friday Five. This is our weekly take on five notable investment themes. Joining me today for The Friday Five is Morningstar's vice president of research, John Rekenthaler.

John, thanks for being here.

John Rekenthaler: Sure thing, Jason.

Stipp: So this week we're going to talk about five interesting themes; first, we're going to touch on PIMCO and target-date funds. We're going to talk a little bit about active managers losing out. We're going to touch on bond funds and active management. Liquidity and outperformance. And finally, we're going to get John's take on the buy-and-hold debate.

So, John, let's start off first with PIMCO and target-date fund asset management. There was an interesting article this week that showed just how much money PIMCO might be managing in that space. Tell us little bit about what you think on that topic.

Rekenthaler: Well, it's quite remarkable. It's no surprise that PIMCO is running a lot of – put a lot of money into the PIMCO Total Return Bond Fund run by Bill Gross, in its own target-date funds, but what Josh Charlson pointed out is in several other target-date funds from other fund families, you not only see the Total Return fund, but you see the allocations increasing, 10%, 12%, 14% of assets--and this is an outside fund family. You don't see that very often with target-date funds. They tend to like to run the money in-house and it's a tribute to the power of not just the nation's, but the world's largest mutual fund.

Stipp: So on the theme of active management but on the equity side, we've seen a trend of people fleeing actively managed equity funds, it is something we've seen it for a while. What's your take on that and the move. Where is the money going if it's leaving the actively managed funds?

Rekenthaler: For five years now, we've seen money flowing out of actively managed stock funds, and some of it is going into bonds, particularly after the 2008 market crash. We see record inflows into bond funds. But actually, there were positive inflows in equity funds--they just happened to be index funds, whether it's index mutual funds or exchange-traded funds.

So, it's really behind the scenes. You see the headlines, and you see money flowing out of stock funds or maybe flat into stock funds, and money into bonds, and we think stocks to bonds; that's part of it. But part of it also is active managers on equity funds--people are fleeing them and putting their money into index funds, whether mutual funds or exchange-traded.

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Stipp: Do you think this is foreboding for active management, or do you think this is just one of those, pendulum is shifting this way, at some point the pendulum will shift back the other way?

Rekenthaler: Well, it is part of a long-term trend. I was interviewed on this subject almost 20 years ago, giving away my age here, and at the time, I predicted that we could potentially see over several decades, and we're only two decades into it, so I've got more time, that 30% of equity assets would be indexed. That was my prediction. We're not there yet. I am not quite sure what the numbers are, but we may get to 30% when I'm still working on this job.

It's a long-term trend, but I also think there is a reaction of the 2008 market. People were disappointed that active managers didn't deliver. They had said for years: Hey, we're trailing in bull market, but when the market goes down, we'll know to run to cash. And they didn't do that. As a whole, they did not outperform index funds.

Stipp: So, the move to passive investments is something that we're seeing on the equity side. On the fixed-income side, however, we did see some active mangers actually hold it pretty well in 2008. What do you think this says about bonds and active management? Is the bond fund space a better area for active management based on what we're seeing from these fund flows?

Rekenthaler: Well, it is based on what PIMCO has done, right? They are really the exception. PIMCO Total Return Fund in 2008 still outperformed, and PIMCO as an organization, and as a result, you'll see there is a faith in active management with bond funds. People are not really pursuing indexes in anywhere near the same way in fixed income. They're looking for active managers, and Bill Gross and PIMCO are the most notable example, but there are some others as well that have benefited.

So, I'm scratching my head on this a bit. It doesn't make any sense to me that in the bond market somehow active managers are able to be intelligent and successful and outperform indexes, and in the stock markets they cannot.

What I also haven't made sense of is, when you look at Yale's funds or CalPERS or Harvard's or the big institutional pension funds. They believe very actively – very aggressively in active management. They have very large portions of their assets in active stock managers. Now, they may be hedge fund managers or they're not necessarily buying it through the mutual fund format.

So, I think we have a little bit of an unsolved puzzle as to why active equity fund managers are so unpopular right now as a group and that the distaste for active management doesn't spillover into bond funds and hasn't spilled over at least as strongly on the institutional side.

Stipp: Certainly an interesting phenomenon. So anyone who does seek active management obviously what they're looking for is some kind of outperformance. Morningstar is doing some research in one area where you think there could be opportunity for outperformance and that has to do with liquidity, the liquidity of stocks. Tell us a little bit about what you guys are looking at there and what you found?

Rekenthaler: Yeah. For a couples of years now Roger Ibbotson, who is associated with Morningstar, and founder of Ibbotson Associates, has been doing work on looking at less liquid stocks versus more liquid stocks and seeing, is there a difference in performance? The theory being maybe liquidity is a risk factor, the same as we saw there is small-cap effect in small company stocks over time--they tend to outperform larger company stocks. Or value stocks over time, the research has shown, tend to outperform growth stocks. Well, perhaps less liquid stocks outperform more liquid stocks or stocks that trade or are harder to trade; there is some sort of risk clearly you take in owning those and maybe there is a pay off.

And Roger, at the individual stock level, has found that to be true, and Morningstar is in process of working on a study now saying, okay, how does that translate to mutual funds? If you bought mutual funds that owned less liquid stocks, how would you perform compared to the funds that owned the more liquid stocks?

And what we found preliminary over about a 15-year period is, it's about 300 basis point or three percentage point difference between if you owned the funds that were in the top quintile or had the least liquid stocks versus those that had the most liquid.

So, 300 basis points a year is pretty good, particularly when there doesn't actually seem to be extra risk in terms of, at least measurable volatility. So, it's been an attractive package. So, perhaps that's a ray of hope for those who are looking for some hope with active managers who've been pretty beaten up in terms of the perception over the last few years.

Stipp: Well, certainly look forward to hearing some more from you…

Rekenthaler: Yeah, this is unpublished. I'm not even sure I'm supposed to talk about it, but for you Jason, secrets come out.

Stipp: Well, I thank you for that, John.

The last thing I'd like to get your take on is, we on this week been having a discussion among ourselves and with readers about buy and hold. This is a philosophy of portfolio management that has taken some knocks recently, especially after 2008.

There is a lot of folks that are saying that they're not going to try the "buy and hope" philosophy, they are calling it, anymore, that it just didn't pay off for them when the market was really in crisis mode. I'd really like to get your take on buy and hold. First of all, how you define buy and hold? And do you think that we have to really rethink this way of investing that folks have been following for so long?

Rekenthaler: Well, I define buy and hold as something we have a strategic plan for your portfolio. It's probably one that you're going to stick to for a number of year, although your circumstances change and you'll check back in on it. And then there is periodic rebalancing. I'll also accept a little bit of tactical allocation within a buy and hold, where somebody based on how the markets have been or some market signal will tinker with their adjustments, but only in a moderate way.

The reason I've been reading this debate closely is it just reminds me so much of when I started at Morningstar, started at Morningstar in February 1988, this was four months after – if I have done math right, yes, four months after the October 1987 crash. So, I started right after the crash, and I can tell you right then, the words were different, but the sentiment was exactly the same. October 1987 proved that buy and hold didn't work. Well, it certainly didn't work for the three-month period from August to October '87 when the market dropped 35%, 40%.

On the other hand, those who said that buy and hold was dead, certainly they weren't around 10, 15 years later because they came to market with a lot of funds--tactical asset allocation funds at the time where all the rage--most of those funds never lasted more than a decade, they performed poorly, they were out of the market, they missed the rallies.

And so, I ask what's different now, and I don't think – I mean, yes, we have the Internet now, we didn't have the Internet then, and so forth, thanks to Al Gore. But I think the fundamentals of the markets, people's personalities, the issues are just the same as 20 years ago, and I think the natural reaction is after you have a very tough market crash, you say buy and hold didn't work, cause it didn't work over the last year. But, generally speaking, buy and hold does work pretty well under most conditions and my guess is now that we have that crash out of the way behind us, it probably is a pretty good strategy for the next five to 10 years.

Stipp: Well, certainly, I know whenever I hear the words "it's different this time," red flags from me for sure.

Rekenthaler: Sometimes it is different, but I just haven't seen any evidence why it is different this time, except "buy and hope" is a different phrase than we heard 20 years ago. So, that's different.

Stipp: Always something new anyway. John, thanks for joining me.

Rekenthaler: Thank you.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.