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First Quarter in Funds: Big Winners and Performance Trends

Christine Benz
Shannon Zimmerman

Christine Benz: Hi, I'm Christine Benz for Morningstar.com.

U.S. stock market indexes notched very strong gains during the first quarter, and U.S. equity mutual funds did well, too. Joining me to recap some of the performance trends is Shannon Zimmerman. He is associate director of fund analysis with Morningstar.

Shannon, thank you so much for being here.

Shannon Zimmerman: Good to be with you, Christine.

Benz: Shannon, a very strong quarter for U.S. equity markets. Let's talk about some of the major indexes and how they performed.

Zimmerman: Sure. Well, all the major indices are up fairly substantially, by double-digits. The S&P 500 is up more than 10%; the smaller-cap indices, the S&P 400, which is a mid-cap index, and the Russell 2000, which is the standard small-cap index, are up even more, about 12% each. So, on the domestic side, it's been a pretty impressive run so far in 2013. Internationally, it's a little bit different.

Benz: OK. Coming into 2013, a lot of pundits might have said large-caps are the place to be, maybe foreign stocks are looking more attractive than U.S.; we really haven't seen those trends play out.

Zimmerman: No, exactly right. In fact, if anything we've seen the trends that were across most of 2012 continue to play out so far in 2013, and exactly right, managers and pundits have weighed in, and they did at the end of the year and have continued to this quarter amid this run-up, to say… international markets look undervalued relative to domestic, and inside the domestic space, the larger-cap names look more attractively valued than smaller. That's not the way investors have behaved, though, so far. If only on the margins, smaller-cap companies have fared better than the larger-cap companies.

Benz: When you drill into the U.S. equity fund categories year-to-date, what are the standout categories; it sounds like large-caps haven't performed as well?

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Zimmerman: Well, what do you know? So, the patterns that we have seen in terms of performance among the major indices have played out at the level of fund categories as well. So you look at Morningstar's diversified domestic categories, and you have to go more than halfway down the list before you see a large-cap peer group, and its large-cap value. Large blend, large growth, those categories have done well in absolute terms, but relative to the other diversified categories, they're at the bottom of the list. At the top, mid-cap value, that's the number one performing category so far year-to-date, followed closely by the small and other mid-cap diversified categories. So, smaller has been better so far on the domestic side.

Benz: And on the value to growth spectrum, it looks like we've seen a little better performance from the value names versus growth?

Zimmerman: Not as pronounced as the effect of market cap, but yes, absolutely, value has outperformed growth.

Benz: Shannon, when you look across our coverage universe, are there any specific funds that jump out in terms of having notched very strong performance in the first quarter?

Zimmerman: Sure. There are a couple that we want to call out, because they've dramatically outperformed the category averages of the categories that they reside within. One is Bridgeway Ultra-Small Company. Now, obviously, it has been in the sweet spot of the market, because smaller names, as we were saying, have fared better so far in 2013, but it's up about 19% so far year-to-date exactly.

Benz: So, it focuses on very tiny companies?

Zimmerman: Exactly right. And that has been the sweet spot of the market, and that's served it well. But also serving it well is … it's a quant shop. It's a bit of a black box, and they don't tell you how heavily weighted any of the screens that they use to put together the portfolio are. One of the screens, though is price momentum, earnings momentum in some cases. And that's had a good run rate recently as well.

And so, in the past, Bridgeway has recently shown quite poor performance, and that has almost moved in tandem with the performance of momentum as a factor as well, and not so much anymore. Momentum has perked up, and it's interesting to see Bridgeway having a fund that's toward the top of the list. Now, I should say that it's not a pure momentum fund at all. They do offer one of those, and this is not it. It's a mix of various quant screens that they use to put this portfolio together--and again, it's a black box--but you have to assume that price momentum is one of them.

Beyond that, … I would call out Bridgeway for its performance, but also for its stewardship practices. The highest-paid worker there at Bridgeway can't make more than seven times the lowest paid worker, and they give half of the corporate profits, not the fund profits, they give half of the corporate profits away to charity each year.

Benz: One other one that jumped to the top of your list, Shannon, was Fairholme, but not the big Fairholme Fund, Fairholme Allocation. Let's talk about what's going on at that fund.

Zimmerman: It's like the black sheep of the Fairholme family. Fairholme Allocation, which only has about $307 million in assets, and Bruce Berkowitz, who manages both the big Fairholme Fund, which has about $7.7 billion in assets and manages this one as well, has closed at the end of February. Fairholme Allocation is closed.

And it's an interesting fund. It resides in our mid-cap value category, and it's, again, substantially outperformed the category average there. It's up about 18% so far year-to-date--strong, strong performance. But it's an oddball fund in lots of ways--only 16 holdings we have in the portfolio data for that fund. And in addition to common stock, it could range far beyond common stock; it owns warrants of Bank of America, JPMorgan, MBIA--actually maybe not MBIA warrants. But MBIA is in the portfolio at the top of the portfolio with about 26% of assets. So, that's obviously a huge position, but it's done quite well so far. But [the funds is] closed currently to new investors.

Benz: So, do you think the fact that this fund is more nimble than Fairholme Fund has helped it outperform?

Zimmerman: Well, you would think so, and the degree of concentration, the names that have done well. But the thing about being nimble, Fairholme is one shop, and it has a lot of money invested, in the big Fairholme Fund, in names that appear in the Fairholme Allocation Fund as well. So, I think it's responsible on Berkowitz's part to close this fund at what seems to be quite a low asset level, and for an individual fund it is quite a low-asset level. But when you think about the amount of money that he has overall invested in these names--and that's the way a fund company has to think about it, I think--it's a pretty dramatic sum.

Benz: And that's how shareholders should approach this thing, as well. If they see a fund that's very nimble and small on its own, they really need to look at whether there are other products that kind of mirror the same holdings.

Zimmerman: That's exactly right and always true. But particularly, if you're struck by how low a fund's assets seem to be and the fact that it's closing. Well, wait a minute, there seems to be a disconnect here, because fund in the mid-cap value category on its own can certainly accommodate more than $307 million in assets, but wait a minute, what's he invested in, and does he have other vehicles that have significant sums invested in those names, and in this case, it turns out, he does.

Benz: Let's take a look at international equity funds for the quarter--not as strong a quarter as U.S.-focused equity funds had.

Zimmerman: That's right.

Benz: One bright spot, let's talk about what's going on with international equity funds so far this year.

Zimmerman: In some ways, it's a tale of two markets. So, if you look at the EAFE, which is sort of the S&P 500 of international stocks, the EAFE is only up less than 4%--about 3.8% year-to-date. So, it has dramatically underperformed the domestic market.

But if you look within the international market, there is Japan and everybody else. And Japan is having a remarkable run, or at least the equity markets are having remarkable run, up about 14% year-to-date, and it's been rallying hard for a while. But the rest of the international markets are subdued by comparison to Japan. And it's kind of interesting in a way, because it's not as dramatic, but it somewhat reminds you of what happened on the U.S. side in 2009. Japan's economy remains mired in what seems like perpetual doldrums, but yet the stock market is shooting up.

[We had] a similar circumstance in the U.S. in 2009, where you had the most speculative names racing ahead beginning in March of that year through the end of the year, while the economy still seemed to be trying to recover and struggling to do that. Again, not as dramatic on the Japanese side, and there are lots of managers who have long been fans of Japan, seeing the culture of the stock market as becoming much more shareholder friendly …

Benz: We've been hearing that for 10 years now ...

Zimmerman: It's true, it's true. It's almost like with bonds. Oh no, with those yields, there is only down to go. It takes a long time for that to play out sometimes.

But managers that have gravitated toward that part of the market have often argued over the past decade that valuations there are depressed relative to the fundamentals of the companies for that very reason--that people have the ongoing perception that Japan is not a very shareholder-friendly culture. Certainly in terms of investment results, this year--that's proving not to be true. It's the top-performing international market.

Benz: So, there is Japan and then everything else. Are you seeing any trends when you look at the diversified foreign stock categories in terms of their performance?

Zimmerman: Not really yet, nothing that you can sort of point too that is as dramatic. … And even on the U.S. side, we're really talking about 2 percentage points of difference between the smaller-cap categories and larger-cap categories. Whether or not that's pronounced or that continues over the next three quarters, well, that remains to be seen, but still that trend seems to be stronger on the domestic side than it does on the international side. It's a close race.

Benz: I guess a question for investors at this point in time that they might have in mind is, these are very strong returns. Is it sell in May and go away, given how strong the market has been in the first quarter? Should you think about rebalancing out of stocks? How should investors approach that question?

Zimmerman: It's a really good question, and quite right. So, we've been on a run for quite a while now, and by historical standards, this is a lengthy bull run. It doesn't feel like it, because of the shell-shocked way that a lot of folks feel coming out of 2008, but the market has been on an upswing for quite a while.

You never want to participate in anything that looks like market-timing. But I think responsible investors always want to look at their portfolios on a quarterly basis to say, wait a minute, so given where things have gone over the past quarter--or in this case, we're in the fourth year of a recovery--is my allocation what I want it to be? Because you always want to have that game plan and that blueprint relative to your risk tolerance and timeline. And when the market runs up, things can get out of whack. At the very least, investors will want to have a look at how their current portfolio is allocated relative to what they started with as a game plan, and if the divergences from that game plan are significant, sure, consider rebalancing. I think that's always a smart move, because you end up rebalancing into the unloved, or what has been relatively unloved, and that's usually a good idea because cheaper stocks have higher to rise.

Benz: Well, Shannon, thank you so much for sharing your insights.

Zimmerman: Absolutely Christine, good to be with you.

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