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Fund Investors on the Knife Edge

Christine Benz

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. With the first quarter of 2011 coming to a close, we thought it would be worthwhile to sit down and talk about some of the performance trends that we've been seeing in mutual funds.

Here to do that with me is, Kevin McDevitt. He is editorial director for Morningstar.

Kevin, thanks so much for being here.

Kevin McDevitt: Thanks for having me.

Benz: So, Kevin, what we've seen in the first quarter is small- and mid-cap strongly outperforming large. What's driving that trend?

McDevitt: I think there are a number of factors at work. We've been, as a firm, and certainly myself included, we've been calling for the resurgence of large caps. It hasn't happened, and I think there are a couple of reasons why that's the case.

One is, I think, small caps more than mid caps--and more than large caps, certainly--benefit from the current monetary environment we have with the Fed funds rated at zero, and with QE2 and things like that, you're pumping a lot of liquidity into the system, and small caps tend to benefit from that more than large caps to some extent.

Then you also have the fact that with all this money flowing into the system, you also have more M&A activity potentially coming down the pike. And I think that also tends to benefit small and mid-cap stocks.

All of that said, and as you've pointed out and others have pointed out, investors need to be very cognizant of the fact, though, that small caps relative to large caps are trading at huge premiums by historical standards. So, in terms of going forward, I think you really want to be mindful of where valuations are now for smaller-cap stocks.

Benz: Okay. So, another thing I want talk about, Kevin, is the strong outperformance in energy stocks. They really trumped every other category in our database for the first quarter. People know probably the major factors driving that, but I'm wondering if you can kind of review them for us.

McDevitt: Sure. I think the main thing, as you might imagine, is the spike in oil prices. Given what's happening in the Middle East, you have a huge runup in the price of oil, and the energy stocks naturally are a big beneficiary of that.

You've even seen a spike, to some extent, in the price of natural gas, too, which, as a lot of oil and gas companies have been shifting a bit in terms of their portfolios to natural gas, that also benefits them. Again, natural gas hasn't spiked to the extent we've seen in oil, but there is somewhat of a carryover effect there.

Benz: So, I know that the natural resources and energy-specific funds have done really well as a result of these trends. How about diversified funds? Are you seeing any diversified fund managers betting heavily on these areas, and in turn benefitting from them?

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McDevitt: Yes, you're seeing that more on the value side. ... With a lot of energy stocks you tend to have fairly attractive dividend yields. So any funds which tend to be more dividend focused, more yield focused have also tended to have relatively energy stakes. So those types of funds do benefit.

Benz: So, Kevin, I want to shift gears and talk about what's going on internationally. Japan, obviously, has been in crisis recently, and I'm wondering if you can talk about the ramifications of the Japan crisis for foreign stock funds?

McDevitt: Sure. Just to start with, initially the Japanese market after the earthquake, tsunami, and then what's happened with the nuclear power plants, had about a 16% drop. You've had a subsequent strong rally, but the Japanese market is still down about 8% year-to-date.

I think it's good to keep in mind, though, that, as others have pointed out, the average foreign stock fund has about 12% to 18% of its portfolio in Japan. So even though it's the third-largest economy, it's still not a huge part of the average portfolio. So for most investors, they haven't been hit that hard by this.

And there's also the fact that during this time, and for the year-to-date, the euro has actually been pretty strong. It's up about 5% versus the dollar year-to-date. So that's provided some ballast, even though European stock markets haven't been performing that well, the fact that the euro was up against the dollar has helped mitigate some of those losses, especially when it comes to Japan.

Benz: And it sounds like some diversified fund managers are actually thinking that there is value in Japan, that maybe was a little bit oversold during the crisis?

McDevitt: Absolutely. It seems like that's been the predominant sentiment, to some extent. You have seen a lot of bullish sentiment, and everyone from Warren Buffett to David Herro have been, I don't want to say "pounding the table," but certainly have looked at this as a buying opportunity. And so far, again, we have seen somewhat of a rally off the bottom, but there is still a lot of uncertainty there; there are still a lot of things that need to shake out, especially as it pertains to the radiation leaks. A lot of things are happening there, and there has been quite a bit of disruption to supply chains, too. So, this story is still unfolding.

Benz: I want to talk about emerging markets, because performance had been so hot there but at least in relative terms not as hot in the first quarter of 2011. Why the cool-off?

McDevitt: Sure. I think there were couple of things going on there. I think one is just what you are seeing in terms of inflation in emerging markets. It's been much more of a problem there than it has been in the U.S. and other developed markets so far.

I think also with what's happening in the Middle East, although it certainly has a smaller impact, but you have had kind of an unsettled geopolitical situation. I think that's created some fear. But more than that I think it is the specter of inflation, and you've had central banks, in Asia in particular, starting to raise rates and trying to fend off inflation.

But I think it's a struggle, because no one country really has that much control over global inflation, but I think if you are looking at emerging market consumers, for example, things like an increase in food prices has a much big impact on their spending than it would perhaps in a developed market.

Benz: Now, Kevin, you mentioned foreign currency and the euro's relative strength so far, and I know that you cover some of the world bond and emerging-markets bond funds. What's going on in general with those fund types?

McDevitt: Sure. It's kind of a similar story again. There more than with equity funds, you're going to see an impact from inflation. So the more that you have fears of inflation in emerging markets, potentially the more that's going to hurt bond prices there.

There is debate about how much of impact inflation has in emerging markets when it comes to fixed income, but if that fear becomes entrenched, I think it's going to have a negative impact, and you're already starting to see things like rates going up, and that's on top of other issues which are facing these funds, such as currency controls and other efforts that emerging-market countries and governments are trying to do to mitigate some of the flows that have gone into those markets.

Benz: How about bonds, generally, not just the foreign bond funds or the world bond funds. It looks like investors appear to be embracing risk, when you look at some of the categories that have enjoyed really nice returns recently. So bank loan, high yield. Is that what you're saying, too?

McDevitt: Absolutely, it's a very strong theme--one we've seen going back for a few months, but it seems to only be getting stronger--and that is you see investors shying away from taking interest rate risk--that is, most investors want to stay short in terms of maturity and duration. But they are very willing to take on credit risk. And you've seen it to some extent with emerging markets, but especially as you mentioned with high-yield and bank-loan funds. And to be honest, it's an area of concern for us, especially what we see happening with bank-loan funds. In the first two months of this year, we saw they had greater inflows than in any previous calendar year.

So there's just a huge rush into these funds, and my sense is that investors look at bank-loan funds, which are not as affected by interest movements, not as hurt by that, they may look at this as a way to get yield without having to worry about rising interest rates. So you see a lot of investors going into these funds, but I worry that they may not be aware of the credit risks and some of the things that can happen in this group. Bank loan funds got destroyed along with other high-yield funds in 2008.

Benz: Right. Any other trends in terms of investor purchases and sales? I know that you would follow that area for us. What are you seeing?

McDevitt: Sure. Well, one of the big general themes has been just the general return to U.S. equities. U.S equities, especially large caps, had been shunned for all of 2010, and for a lot of 2009 for that matter, and you are finally starting to see some investors coming back to U.S. stock funds this year, and including the large caps. And that had been among the most unloved categories in 2010.

Benz: So, overall, being willing to embrace risk on the fixed income side, but also rushing into equities to some extent as well?

McDevitt: Yes. So, you are right. It's very much that broad theme of embracing risk across the board. That said, what we have seen, you did see some slight flows out of emerging-market equity funds last month in February. It's the last full month we have. And those after only a slight downturn in emerging-market equities, nothing too severe. But it was different from what we were seeing with S&P 500, which was rallying at that point. And the takeaway is, I think, just that investors are very much on a knife-edge. They will switch very quickly, and there is a sense of rushing to take on risk, but then shying away very quickly, if there is any sense that that market is volatile or if prices start falling.

So, unlike maybe in years past, where we saw a bit more resilience when there was volatility, now it just seems like once the market turns, investors are very quick to kind of move on to a different asset class or category.

Benz: Okay. Well, Kevin, always great to hear your insights. We appreciate you being here.

McDevitt: Thanks for having me.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.