Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm here today with Shannon Zimmerman. He is an associate director of fund research at Morningstar. We are going to look at what funds have performed well so far in 2012 and his expectations for next year.
Shannon, thanks for talking with me today.
Shannon Zimmerman: Good to be with you, Jeremy.
Glaser: So, we're almost done with 2012. Let's take a look at the big picture. What categories have done well? What hasn't done so well?
Zimmerman: Well, so, among the diversified domestic-equity funds, our categories that track those funds, bigger has been better for the most part. We saw that earlier in the year when [Morningstar director of personal finance Christine Benz] and I last talked about how the lay of the land was looking. Large-cap funds--the large-cap value, growth and blend peer groups--were one, two, three at the top of the charts in terms of performance.
That's changed a little bit. You look at the top four, two are large caps, and two are mid-caps. Small cap has not done nearly so well as it has in the recent history anyway. It looks like maybe some of that valuation ground is being made up because after the very lengthy runup for small-cap stocks and the funds that invest in them, it's a little bit of a reversal of fortune with the bigger funds doing better.
Glaser: How about growth versus value?
Zimmerman: Earlier in the year, we saw, it wasn't a wide margin but a pretty consistent pattern where growth funds across each of the diversified categories--the large, mid-, and small--growth funds were trumping their value counterparts. That kind of evaporated over the last few months. And so, while market cap has been a determiner, the valuation spectrum, growth versus value, has not really had much of an impact. Large growth is the top-performing category on the year, but mid-growth and small growth are at the very bottom of the list.
I should say that all the categories did quite well on absolute terms. Everything is up more than 10% on the year, and there's not a huge margin between large growth, which on average has earned 14% in 2012 so far, and small growth, which is barely above 10%. So the margin of victory isn't huge, but in terms of that market-cap boost this year, it's been pretty consistent.
Glaser: Let's take a look at fixed income. What's worked so far this year? What hasn't?
Zimmerman: Fixed income is really quite an interesting category, and the more you delve into it, the more interesting it becomes. And so you see all these outflows from equity funds and then you see all these inflows into bond funds, and you think, "Well, investors must be getting very skittish, and so it's a risk-off environment."
That's not really the case. I think we talked about this maybe last month as well, but it's remarkable the degree to which the assets that are flowing into intermediate-term category bond funds--which is pretty plain-vanilla of a category--are coming from money market accounts. And so it isn't as though people are dialing down risk. It could be relative to a money market account, an intermediate-term bond fund is a risk-forward gesture.
So, with that as a backdrop, it's interesting to look at what the top-performing categories in the fixed-income side have been because it's clear that people are kind of scrambling after yield, which is very hard to come by these days in a very low interest-rate environment, by going for more exotic and riskier fixed-income investments. Emerging-markets bonds is the very top-performing category on the fixed-income side so far in 2012, up about 16% this year.
Glaser: Certainly past performance can be pretty interesting. It's a fun exercise, but people are really interested in what's going to happen next year. If we see this kind of volatile but still up market again in 2013, what funds would you expect to perform well and what funds would you expect to struggle?
Zimmerman: It's an interesting market environment because it's not like 2008, which was lethal for so many portfolios or nor is it like 2009, which was led by the most of rickety kinds of companies, that didn't have earnings and had very unhealthy balance sheets, and people were stampeding into risk.
You can't call [this market environment] Goldilocks because it was quite volatile. If we look at the stats, a fund like Fidelity Leveraged Company Stock did quite well this year. And part of the reason for that is that funds on average that have higher debt/capital ratios, meaning that they invest in companies that have weaker balance sheets, marginally outperformed, and Fidelity Leveraged Company Stock actually outperformed disproportionate to what that advantage should provide.
So, it's a very tough year to say, "Oh, this was the environment that the investors had to put up with and these are the kinds of funds that did well." If that persists, I don't know. I think funds that have managers who are really excellent pickers of securities will do well, but that's true of any environment.
Glaser: So, what are some of those funds that you expect to be good picks for 2013?
Zimmerman: Oakmark International is having a fine year this year, all of its trailing returns up to the 15-year period. [During that period, the fund has] been presided over by David Herro, who is [a past recipient of the Morningstar International Stock Manager of the Year award]. I would expect this fund to sort of prudently do well.
Now it is a contrarian fund, in some ways, in fact, it's quite heavily exposed right now to European financials, and not safe-haven insurance companies either but banks. Its largest industry exposure is to commercial banks and then capital markets companies, as well. So, he hasn't played it safe and that's kind of typical for his fund and for Oakmark in general, because they go where volatility is on the theory that a lot of times when there's sell-off, there's a "baby with the bath water" sell-off.
And so if you go for quality--which they do, that's the big risk control across each of Oakmark's funds--Credit Suisse is in the bank sleeve of his portfolio, not some of the more rickety banks in Spain or Italy, for instance. If you take advantage of the volatility by going into quality names that have been marked down irrespective of the health of their fundamentals, that can be a smart thing for long-term investors.
Glaser: Certainly, when evaluating funds, you going to look at more than just performance, just the category's performance. When you look back at the year, what funds or what trends have you seen that have been kind of a gift, a holiday gift for investors?
Zimmerman: Well it's a good question this time of year, and I always encourage investors to look beyond performance, right. So everybody can look at the returns and you do research presumably here at Morningstar.com, and come to a conclusion about the funds you want to consider for your portfolio. But then you really start separating from within that universe of really strong funds, what criteria should you use? Stewardship matters hugely to us in the fund research group [at Morningstar], and I think it should to every investor.
And by Stewardship, what we mean is, is the fund company--the fund managers, the company behind the fund the parent organization--are they truly aligned with shareholders? Do they really operate with shareholders' interests first and not their own. So some proxies for that, some ways of determining to what degree a fund, a management team or a fund company, really are aligned with shareholders would be things like a managerial investment in the fund. Do the folks who run the fund, are they also shareholders in the fund, and if not, why not? We like to see managers, particularly those who are long-tenured, have at least $1 million in the fund, $1,000,001, that's the top band that the SEC mandates and that information is available in the statement. It's a very boring name for a very exciting document, the Statement of Additional Information. So, that's one way the investors can determine is the fund company really aligned with me in terms of the managers' investment in the fund.
Expense ratios that fall as assets under management rise, that's huge, and in a way that's proportionate to the increase in assets, as well. If a fund company enjoys an asset base that doubles year over year and the expense ratio falls by a couple of basis points, well that's nice, but that's not really proportionate to the increase in assets.
Then finally, I would say, has the fund company historically been willing to close funds before they get too big, so big that they kind of impede their manager's ability to execute their strategy? And we did see one terrific example of that. Usually that's more of a pressing issue for small-cap funds, right. So you're moving into these small names; if you have large sums you're going to move the price of the security you're trying to purchase. You've got to move the security price up when you're trying to build a position; you've got to move it down when you're trying to exit one.
The fund that I'm going to call out is not a small-cap fund. It's a large-blend fund, BBH Core Select. It's a bank-run mutual fund, and it's sort of unique in that it's really shareholder-friendly and a very successful fund that's run by a bank. There aren't many of those. And so, not only do they close the fund at $3.5 billion--again, it's a large-cap fund, and it is constrained. It has about 31 names in the portfolio, so that's a constraint. But still the portfolio comprises exclusively large-cap, highly liquid names. And so, not only did they close it at $3.5 billion, they preannounced the close, and they stuck to their guns. They preannounced the close I guess [several weeks ahead of time], and then on Nov. 30, it closed.
That doesn't happen too often in the fund world because obviously the bigger the asset base, the more revenue the advisor derives, but also the more the shareholders in the fund at present have at risk. [This is because] if the managers of that fund had to put more money to work than they actually wanted to, they might have to add names and water down their strategy, and they just weren't willing to do that, even if it meant not having a fatter revenue stream.
Glaser: It's always a good idea to look a little bit past just those performance numbers.
Zimmerman: Absolutely, it is.
Glaser: Shannon, thanks for coming in today.
Zimmerman: Good to be with you, Jeremy.
Glaser: For Morningstar, I'm Jeremy Glaser.