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Hitting the 3 Sweet Spots of the Market

Christine Benz

Christine Benz: Hi. I'm Christine Benz for Morningstar. Mutual funds posted exceptionally strong gains during the first quarter as investors embraced risk-taking. Joining me to discuss some of the latest trends in the fund world is Shannon Zimmerman. He is associate director of fund analysis for Morningstar.

Shannon, thank you so much for joining me.

Shannon Zimmerman: Thank you for having me, Christine.

Benz: Shannon, on the top of your list of things you'd like to talk about are some of the trends we've been seeing in mutual fund inflows and outflows. It's been pretty interesting to watch investors gravitate to bonds.

Zimmerman: Absolutely.

Benz: Has that continued to go on?

Zimmerman: It has. We don't have the data yet for March. But I think that the trends that we've seen so far on the year-to-date period will probably persist, and yes, people can't stop stuffing money into taxable bond funds especially. What you said is exactly right. This year has been a strong year for domestic equities. The S&P 500 is up about 12%, and so is the Russell 2000. So you have these broad market indexes for the large-cap and small-cap sectors doing quite well. But that's not where the fund flows are going, at least in terms of mutual fund flows.

Benz: Is it just that the financial crisis was such a searing experience that people really don't care about the upside as much as they care about not losing again?

Zimmerman: You have to imagine that that's a part of it, right? It's a shell shock still to this day. You look at the fund flows going in torrential amounts into taxable bonds, but the returns that folks are getting there are quite tepid. I think that for the year-to-date period, the typical taxable bond fund is up around 2%, and yet that's where the lion's share of assets have been flowing into. For better or worse, usually we preach against performance-chasing, and in this situation it might be wise to heed that given how low bond yields are right now. How much more upside is there if you focus on total return for the average bond fund? It might be that equities are looking more attractively valued relative to bonds now.

Benz: I know you keep track of what's going on with equity fund flows. You noted that the flows out of equity funds at least have moderated a little bit.

Zimmerman: That's right. The pace of outflows has slackened. You and I were talking before this segment that if you add in exchange-traded funds, it looks even more attractive for domestic equity funds. So as soon as I get back to my desk, I'm going to do a little research on that one.

Benz: So, once you add back in the flows that we've seen into some of the equity ETFs, it's maybe even a better picture for domestic equity funds?

Zimmerman: Exactly.

Benz: Let's talk about some of the big winners in the mutual fund world so far. Technology has been a big winner and certainly the sector funds there. Financial-services funds have been winners, as well. What's driving that?

Zimmerman: You said earlier that the investor appetite for risk is back, and that seems to be a part of it, too. Obviously we should qualify this. It's a year-to-date period, a very, very short period of time. Things thing can turn on a dime. The last time we got together, we talked about how January and February activity had looked quite different. What did well in January didn't do so well in February, but with those qualifications out of the way, on a year-to-date basis the three sweet spots of the market are the technology, financials, and consumer cyclical sectors. They have been the ones that have fared the best and so that is sort of a profile in courage in terms of investors cottoning to risk again.

Benz: How about the Morningstar Style Box view when you look at large-cap funds versus small caps or value versus growth? What kind of performance trends do you see there?

Zimmerman: Well the interesting thing there is that its a rare sighting of growth outpacing value during the past decade. I think that has to do with the particular period of time that you look at as the measurement period. People got stung by two bear markets in the last decade, and some of the same trends that we're seeing in terms of fund flows into bond funds rather than equity funds is a dynamic that's in play there too. People have become more cautious and justifiably so. But during the first quarter anyway, growth funds have outpaced value funds, and that doesn't happen too often.

Benz: Did this risk-on appetite extend to international-focused funds, as well?

Zimmerman: It did in terms of investor flows. In terms of our international categories, flows into international funds have been positive. They are much better than what we have seen on the domestic-equity side.

Benz: In emerging markets in particular, right?

Zimmerman: Exactly, people still have an appetite for that kind of risk as well, and to the significant extent that foreign funds are outperforming in terms of flows into domestic-equity funds, it's driven in large part by interest in emerging markets. It's sort of a schizophrenic investor profile right now because you have all this money going into bond funds and then when you look at the areas of mutual fund world on the equity side, it's emerging markets that are doing the best. So, it's risk-on, risk-off even within the typical investors' own patterns right now.

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Benz: So emerging markets had a terrible year in 2011. They've performed relatively better so far in 2012, correct?

Zimmerman: Certainly, relative to 2011, that's right. But when you look at the international categories, the China-region categories are the ones that have fared the worst actually. In absolute terms, it's a decent return, a double-digit return I think of about 10.0%-10.5%. China has been a great investing story during the past decade. How long can it keep up its torrid rate of growth? The Chinese government has actually dialed down its targeted gross domestic product for the next fiscal year, and that's scared a lot of investors. But no one should expect that China is going to be able to grow in the next decade the way that it has in the past. There's some more infrastructure build-out that has to occur, but maybe the gold rush days in China are over.

Benz: Now it seemed that coming into this year a lot of the value managers we follow thought that there was a lot of value in developed foreign markets, in some of the European stocks that had been so badly beaten down. Have those rebounded in 2012?

Zimmerman: You look at the bottom of the international list, and the China region is at the very bottom. Again, it has decent absolute return. Then Japan is the next worst performer, but, again, it has a decent absolute return. So the funds that are more broadly diversified to include exposure to developed parts of international markets, Europe in particular, have fared better in relative terms to those that are more targeted to Japan and China. But you have to cherry-pick among the funds that are led by people who are really strong stock-pickers and have the courage for their convictions. I cover Oakmark International, and David Herro runs that. He has more exposure than the average fund to developed Europe and is doing quite well. So you have to pick your battles and pick your stocks in order to succeed in a very turbulent space.

Benz: So, Shannon, I want to segue to some individual fund stories, I know the funds team and you have been keeping very close tabs on Fairholme Fund. It's been holding in many investors' portfolios.

Zimmerman: It's a celebrity mutual fund.

Benz: It's as close as they come. So let's talk about how that has performed so far in 2012?

Zimmerman: Well, it's a worst-to-first turnaround story for Fairholme this year, which makes sense. We were talking at the top of this segment about the areas of the market that have fared the best. Financials and consumer cyclicals are two of the sweet spots for the market. Lo and behold, you look at the portfolio of Fairholme, about 80% of the fund's assets are in financial names and another 12% in consumer cyclical names, which is another sweet spot for the market.

Benz: So another fund that you highlighted, Shannon, is Tilson Focus. You mentioned that it is really in the sweet spot in terms of its positioning.

Zimmerman: Absolutely. Yes, it is. It hit the trifecta. So the three areas again are technology, financials, and consumer cyclicals, and that's where virtually all the assets in that fund are invested. So it couldn't be better-positioned in terms of sector allocation, and Whitney Tilson is a good stock-picker, as well. I haven't run the performance-attribution numbers, but I wouldn't be surprised to see that the factors include not just sector allocations, but individual security selection, as well.

Benz: I'd also like to touch on the big news in the fund world, beyond performance, beyond flows. Are there any key issues that you think are important for investors to know about?

Zimmerman: Sure, we're having a rare sighting of growth outperforming value. That's an impressive trend, because again, it's not seen too often. The drill-down story for me, as you look into the portfolios of value funds, and more and more exposure to technology is showing up there. Some of the funds that I cover, again, to refer to Oakmark funds, they have substantial tech overweightings in a number of their funds. Oakmark Equity & Income, the last time I looked, had more than 30% of assets invested in that sector, and that's a value shop. That's sort of happening more broadly, too. Apple is a part of the story there, as it so often is these days. A lot of value managers are adding Apple to their portfolios because you want to have Apple in your portfolio.

Benz: But that's the thing, if they are benchmarked against the S&P 500, I think your shareholders will say, "Hey, what are you doing here without Apple?"

Zimmerman: Exactly. You have to have it just for appearances sake. Then beyond that, I think that you look at Apple and relative to its own history and relative to the broad market in both current terms and forward-looking terms, even after this fantastic runup--it's up about 75% during the last 12 months--this is a company that's up about 45% on an annualized basis during the last decade, yet still looks relatively attractively valued. And so that's an interesting dynamic. And then a lot of the value funds have requirement for robust financial health.

Benz: Dividends.

Zimmerman: Dividends, right. Now Apple is a dividend-paying company, too. So Apple is gaining in a way a new audience for its shares, and I don't think it's in any jeopardy now of losing the growth audience that it has because its reputation as a brand is so cutting-edge. But that may play out over time in a different way. It happened for Intel and Microsoft; once those companies started paying dividends, the growth crowd kind didn't look askance exactly but sort of became more tepid toward those stocks. I think that's a long ways down the road for Apple, but it could happen eventually.

Benz: You mentioned that actually a few growth funds have shied away or begun downplaying Apple?

Zimmerman: Yes. There are a couple of examples. American Funds Growth Fund of America has trimmed its position. Fidelity Contrafund has, as well, but Contrafund is sort of an eclectic fund anyway, so it would be hard to peg that trend to that fund. But still, it's interesting to see that as Apple stock rises among value investors, it has been trimmed, at least at the margin, in a couple of prominent places.

Benz: Interesting. Well thanks Shannon for sharing your insights on the fund world. We appreciate you being here.

Zimmerman: Absolutely, Christine.

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