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Despite a Rocky Market, Fund Investors Go for Growth

Christine Benz
Shannon Zimmerman

Christine Benz: Hi, I'm Christine Benz for

Nearly every mutual fund category is in the black for the year-to-date, but it definitely hasn't been a straight line up.

Joining me to discuss some recent trends in mutual fund performance is Shannon Zimmerman. He is associate director of fund analysis for Morningstar.

Shannon, thank you so much for being here.

Shannon Zimmerman: Good to be with you, Christine.

Benz: Shannon, let's start with domestic equity. It's been a volatile year so far.

Zimmerman: It sure has.

Benz: The second quarter was particularly volatile, although June was a great month. Let's discuss the key trend when you look at growth versus value-oriented funds. What are you seeing there?

Zimmerman: On the valuation spectrum there is a definitive trend line, and growth has outperformed value pretty handily--not by a wide margin--but pretty consistently as well, and it's interesting because over the very long period of market history, from 1926 through present, value has typically outperformed, but Jack Bogle did a speech at a Morningstar conference a few years back called the telltale chart, and he pointed out that if you remove just slivers of that time series, the value premium seems go away. So maybe this is one of the slivers where growth is going to outpace value for a while, and it's going to be on valuation grounds, because it's been out of favor for a while.

Benz: So, when you look at why growth has performed so well, what do you conjecture about why investors have preferred growth stocks at the expense of value names recently?

Zimmerman: It's a really good question. You look at it from the level of government on down to individual investors, and now it's not exactly austerity be gone, but folks are talking more about concern for GDP growth, or growth in general, than they are inflation.

Investors may be taking that as a sign as well: If people are going to step on the gas and even Britain, which has been sort of a champion of austerity for a while, is stepping on the gas with a round of quantitative easing, maybe investors have been anticipating that. Maybe they are just more open to risk because the valuations appear quite attractive. I did a panel at the recent Morningstar conference on tech, and a lot of value investors are going into that traditionally growth sector because the valuations look so compelling relative to the health of the balance sheets of the major companies in that sector. Lo and behold, technology has been one of the best-performing sectors this year, and that makes sense given that growth has done so well.

Benz: When you look across the capitalization spectrum, any notable trends there in terms of large, mid, and small-cap funds?

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Zimmerman: Not so much, not so much. The valuation spectrum has been a much better predictor retroactively of how a fund is going to perform this year. Market cap-wise, the top-performing diversified category on the domestic side is large growth, and near the bottom is large value. So, no, there has been no market cap trend.

Benz: How about sectors? When you look at some of the best-performing sectors that have driven diversified funds, or within the sector fund universe, what's leading the way?

Zimmerman: That's interesting, too. So, I mentioned technology and again, during a period where growth has outpaced value, you would anticipate that the growthier sectors would do well--technology being one of them, and consumer discretionary being another of the growthier sectors, and it's also near the top of the charts.

Interestingly, financials is near the front of the pack as well, and that, given the dire straits that some companies in that sector are still in, you have to see that--I do anyway--as a proxy for it being a risk-on environment on the whole year-to-date.

What you said at the top is exactly right. It has not been a straight line up at all. I remember at the beginning of the year, we talked about the dramatic difference--almost a mirror image difference--between January and February in terms of what had done well one month not doing so well the next.

So it has been sort of a rollercoaster ride, but consumer discretionary, technology, financials, and then interestingly, too, health care has been a top-performing sector this year. In a season when growth has outpaced value, you would think that a defensive sector like health care probably wouldn't do as well. But it turns out if you look under the hood, what's driving a lot of the outperformance of the health-care sector is the biotech sleeve of that part of the market.

Benz: So, Shannon, how about the individual fund level? What have been some of the top performing funds year-to-date?

Zimmerman: Through the market close on July 3, and you look at the top 10, five of the top 10 have been funds that are focused on the biotech sector of health care, which stands to reason given how nicely health care has done year-to-date.

Among diversified funds is Fairholme at the very top of the charts, which is interesting because it's, as we have discussed in the past, a worst-to-first kind of situation for Bruce Berkowitz. And I say "among the diversified funds," and Fairholme is, because it's in one of our diversified categories, the large-value category, but you look at the portfolio, and it's tough to call that a diversified fund these days. Last time it disclosed, it only had about 19 holdings total in the portfolio. About a third of fund's assets were at AIG, and 80% of the fund's assets overall were in financials. So, for all intents and purposes, it's a financials fund right now.

Benz: And you've got to be comfortable with that concentration if you are looking at it?

Zimmerman: Absolutely--Berkowitz is a great investor, obviously. But you have to be as patient as he is to succeed with his fund sometimes.

Benz: How about on the other side of the ledger: When you look at some of the category sectors that have underperformed, what are you looking at there?

Zimmerman: Utilities. In a risk-on environment, the more conservative categories just aren't going to do as well, because all the investors are chasing performance in the direction that it's going, and right now, it's going growth.

Benz: It looks like some of the cyclically oriented funds, those that hold basic materials and energy, haven't done as well, either.

Zimmerman: Exactly right. Energy is one of the worst-performing categories year-to-date.

Benz: Shannon do those trends translate overseas when you look at performance among funds that invest in foreign stocks?

Zimmerman: A little bit, but it's not as clear. To get a handle on what's driving performance abroad, you really have to look under the hood of the categories. So, foreign small/mid-growth is the top-performing diversified category among our foreign peer groups, and a lot of that has to do with the emerging markets exposure, which has been a very topsy-turvy part of most portfolios year-to-date.

And under the hood of that, folks sometimes have the notion that emerging markets move in tandem as a block, the BRICs move as a block, but they don't. At the top of the foreign categories for us is the India Equity category, and at the very bottom is Latin America. So, those are two emerging markets, and yet they've performed quite differently. China, is near the back as well. So, it really paid to be choosy when you are picking and choosing which funds you wanted to invest in based on the emerging-markets exposure this year.

Benz: How about Europe? That's the place that has been grabbing all the headlines. How is Europe affecting diversified funds as well those funds that are focused specifically on Europe?

Zimmerman: Well, it's interesting. The foreign large value [category], which has, on average, a pretty significant exposure to Europe and to European financials--which has been a performance driver in the wrong direction for most of the year--that category has not done well year-to-date, but over the last month, it's come roaring back. And you have to wonder, why is that? What are investors betting on? And foreign large value is obviously a diversified category, so it has more exposure than just European banks or European financials.

Still, there is exposure to that area there, and with Europe seemingly so toxic, what are investors anticipating? And maybe they are anticipating concessions from Germany on austerity and more aggressive monetary policy from the ECB, which they have received recently--but maybe not to the degree that some investors were anticipating. When the announcement came that the ECB was cutting rates, the market sold off. We'll see if, over time, as the effects of that cutting are felt, maybe investors will be more pleased by it.

Benz: Now, you and the team spend a lot of time talking to various fund managers. What are they saying in terms of how they are positioning? Those who have a global strategy that they can invest globally, what are they saying in terms of where they are finding opportunities?

Zimmerman: The value hounds are looking in Europe, and they are looking at European financials. David Herro is a great example of that, of Oakmark International and Oakmark International Small Cap. He is not exactly a lone voice on that, but to the extent that other managers are looking at that part of the market, they're not talking loudly about it, because right now, I feel like we're still experiencing the aftereffects of 2008, and investors are very concerned about volatility and very concerned, rightly so, about capital preservation.

So, even if some of the contrarian, value-oriented managers are picking and choosing among European financials, they're not by and large talking about that a great deal. They are talking about playing it very conservatively and are, as the governments are, increasingly concerned more about growth than they are about inflation.

Benz: Now, let's switch gears and talk a little bit about what's going on in fixed income. We have seen these massive ongoing flows into bond funds, and I am curious to hear whether that interest in fixed income has been warranted. Have bonds performed pretty well for people year-to-date?

Zimmerman: Some categories have, and in bond land, it's definitely been a case of risk-on this year. In terms of performance, the riskier categories have done well--emerging-market bonds, high-yield bonds. ... So investors have tilted in that direction, but relative to the amount of money that's gone into intermediate-term taxable bond, it's a drop in the bucket.

True, the role in a portfolio of the more exotic or the more aggressive fixed-income categories is smaller, so that ratio makes sense. But in terms of what's performed well, the flows have not been going, by and large, in the amount that you anticipate, into the categories that have performed best, and those have been the riskier categories: emerging markets, high-yield bond, multi-sector bond as well.

Benz: Shannon, it's always great to hear your summary of what's been going on in the fund world. We'll obviously stay tuned. I am sure there is more volatility to come.

Zimmerman: I think we can count on that.

Benz: Thank you, Shannon.

Zimmerman: Thank you, Christine.

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