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The Friday Five Has Fund

Jason Stipp

Jason Stipp: I'm Jason Stipp for Morningstar, and welcome to the Friday Five. This is our look at five notable themes for investors. Joining me this week on the Friday Five is Chris Davis. He is a fund analyst and we're going to have a fund related Friday Five.

Chris, thanks for joining me.

Chris Davis: Thanks for having me.

Stipp: So this week we're going to talk about some stock-picking opportunities that may be or may be aren't out there; some active fund measurements; we're going to look at fund flows as an indicator; we're going to look at Bogle's beef on fund fees; and lastly, we're going to hit Chris up for a couple of fund pick ideas.

So Chris starting off first, we've seen some trends in fund flows. This was some news that came out a couple of weeks ago. One of the big ones that we've talked about a lot is funds moving into bond funds versus stock funds, but it's not just that they are continuously leaving all types of equity funds; passive funds have actually held up pretty well.

So this seems to say to me that maybe investors don't think there's a lot of opportunity for a stock-picker out there. From the fund managers that you talk to, are they finding opportunity? Are fund managers in offensive mode or are they in defensive mode and they are not really finding opportunities as active managers, either?

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Davis: I think a lot of investors have sort of given up on active management because they look back to years like 2008, they thought their active managers were coming to save them in a really tough environment, and they didn't.

Of course, these investors might have been howling if their managers would have gone into cash during the rally in the mid-2000s, because they weren't able to keep up. So, I guess you have to keep that in mind.

But that being said, a lot of managers, even good managers that we talk to, even those that are pretty conservative are finding opportunities. Steve Romick is one manager I talk to. He runs FPA Crescent, and he's a notoriously cautious investor, and he says he's finding value in high-quality stocks. And managers compare stocks to other investments out there, and when you look at U.S. Treasury bonds that are yielding next to nothing, stocks look pretty decent.

Stipp: So one thing, obviously, that investors want to make sure is that when they are paying for an actively managed fund that they're actually getting something that's actively managed.

You wrote recently about a new measure that can help investors figure out just how actively managed their fund is and what that says about performance. What did you find on that front?

Davis: Well, I wrote about this recent paper written by these academics at Yale and they developed this measure called "active share." And so, for instance, if a fund had an active share of 60, it would mean that about 40% of that fund's holdings overlap with its benchmark, and their finding was that the higher the active share, the more active that fund managers are, the more likely they were to outperform. And we found that researching in the Morningstar database as well.

Stipp: So if they are more active, and that means they might have a better chance to outperform, doesn't it also mean that they might have a better chance of losing money as well?

Davis: Yeah. I think the freedom to shine means you have the freedom to fail, but if managers don't take chances versus their benchmark to begin with, they really don't have a chance of outperforming, or at least their chances are pretty slim.

Stipp: Sure, and certainly you don't want to pay for active management and then end up just basically getting an index fund at the end of the day.

Davis: Right. So I think it's important for investors to not just look at performance, look under the hood and see, does your fund look a lot like the benchmark. If the top holdings are Exxon, and Apple, and Microsoft, well maybe it's just emulating the S&P 500, and so you can go and be like a lot of those other investors that have cast their lot with passive management.

Stipp: There is something else that we've seen from the fund flows, and the third point is, as I'd mentioned before that, a lot of folks are moving into bonds. Pat Dorsey was in this seat last week. He said, fund flows tend to be a contrarian indicator. So if everybody is moving into bonds that might be a sign that equities actually are pretty attractive, and that could be a reason that some managers you've spoken to are also looking at equities.

If bonds potentially aren't the place to be, because that's where everyone is going, what are my alternatives? Is the bond market looking like a dangerous place now based on the fact that everyone is moving into them?

Davis: Yes. I guess I'm a natural contrarian. I don't like to follow the herd. If the herd is going right, I'd like to go left. So I don't have a really hard time not following the herd. But I think equities do look attractive. Ten years ago, if I was sitting in this spot, I would be talking about how investors have been stampeding out of bond funds, because equities were so attractive, and they had a 20-year run, and everything looked great for stocks. So I think the opposite could be true today.

I don't know if anybody really knows whether bonds are in a bubble, and I think the bond market isn't monolithic. But if you look at what really smart investors like Bill Gross, the Bond King from PIMCO Total Return, are saying; they're saying that bonds' best days are passed.

And so, I think what it does mean for investors, is they should have pretty modest expectations for bonds and invest cautiously in them. I think that's what it means. It doesn't mean bonds are necessarily a bad investment, depending on your time horizon and what you're looking to do with your portfolio, but I think you ought to have tempered expectations.

Stipp: So if we are going to have to moderate our expectations for returns, especially in bonds, it seems like it is especially important than to pay attention to fees and to not pay too much on fees, I would say across the board, but especially in bond funds.

This is a topic that came up recently in the Journal with some back and forth between the Bogles, Jack Sr. and Jack Jr., and Neil Hennessy who are arguing on two different sides about fund fees. You took a look at some of their arguments. What's your take on where we are with fund fees, and if they're excessive, and where we need to go?

Davis: Well, Neil Hennessy knows a lot about high fund fees, because his funds have really high fees. But that being said, am I on the side of angels here. I think that Jack Bogle is right. Whether they're excessive or not, his central insight, and it's not an earth-shattering one, is that the more you pay to fund companies, the less you have in terms of returns. It's just a fundamental mathematical premise. And so the lower fund fees win in the end; that's our finding again and again no matter how you slice the data.

And so if you, as an investor, want to stack the deck in your favor, you want to fish in a low-cost pond. I think that's one of Jack's phrases. So I give him due credit for that.

So I think that that's the right take. I agree with Jack Bogle Jr. in the sense that mangers are responsible for setting their own fees. I think expecting the fund industry, though, to voluntarily want to lower their fees is a lot like asking dogs to be against scraps from the table. But I think vigilant investors as well as vigilant fund boards who oversee these funds, you know, should argue for lower fees.

Stipp: Sure. Number five, because I always like to put the guest on the hot seat a little bit and ask him for a pick or something that they found attractive recently.

You have a couple of ideas, one of're the Fidelity Funds specialist on the fund team, so I ask you for something inside Fidelity and you also have another idea, something that you bought recently, can you tell us a little bit about both of those?

Davis: Well, the first one and it's hardly a bold pick or a contrarian pick, given that $70 billion worth of assets are in Fidelity Contrafund, but the manager, Will Danoff, recently celebrated his 20th anniversary at the helm, and so I thought that was pretty notable, and over his 20-year stretch he has beaten the S&P 500 by 4 percentage points a year. So he's up 12%, the S&P is up 8%, and so over a 20-year time period, that's big money for investors, and so he has proof that paying for active management can really be worth it. So for a core growth holding, that'd be my favorite fund at Fidelity.

As for the second, the fund that I recently bought, is FPA Crescent, I mentioned it earlier, and I like it because you have a really opportunistic manager. He refers to himself as a free-range chicken. He'll go anywhere he could find opportunity whether it'd be stocks or bonds or preferred stocks or cash. If he can't find anything, he doesn't spend money.

I am kind of the same way. I went to Macy's across the street; didn't find anything I liked, so I didn't spend money. You know he has the same type of philosophy.

Over the past decade his fund is up 11%, the market is down slightly over that stretch, and it's because he has a really a good nose for value and buys when he finds opportunity and jumps on it.

Stipp: Certainly notable performance, especially in this unusually uncertain economic environment someone who has the freedom to sort of look around for the opportunities could be a good bet.

Davis: Right, you know, he's a naturally cautious person. Sometimes I don't think I am cautious enough, so I am going to outsource my cautiousness to somebody who I really trust.

Stipp: That sounds like a good bet. Chris, thanks for joining me.

Davis: Thank you.

Stipp: For Morningstar, I am Jason Stipp. Thanks for watching.