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These Fund Apples Fall Far From the Family Tree

Christine Benz
Russel Kinnel

Christine Benz: Hi, I'm Christine Benz for

Not every fund with a strong Parent grade garners a high rating in our Fund Analyst Rating system. Joining me to discuss some of these parent-child discrepancies is Russ Kinnel; he is director of fund research for Morningstar.

Russ, thank you so much for being here.

Russel Kinnel: Good to be here.

Benz: Russ, we've been doing these analyst-driven ratings for more than a year now--about a year and a half now. They are designed to be forward-looking ratings of a fund's future prospects.

When you look across some of the ratings … you [may] see funds that actually have high Parent ratings, so we like the fund company, but the fund doesn't garner as high a rating overall. Let's look at some examples of where that occurs, and let's start with a Vanguard fund.

Kinnel: Vanguard Morgan Growth is a fund that really just is kind of a bland fund. The really good actively managed funds from Vanguard have the low costs that you see in their index funds, not quite as low, but they have portfolios that are very different from the indexes.

Vanguard Morgan Growth has five sub-advisors, however, and so it ends up with a portfolio that's not too different from an S&P 500 fund or a large-growth index fund. So you have a very diffuse portfolio, and therefore it tends to have fairly bland results.

Benz: So it has quite low costs on its side, though. So, even despite that fact, we think that investors might look elsewhere for that sort of large-cap growth exposure?

Kinnel: That's right. It has low cost, it has a good parent obviously in Vanguard, and parents are a huge part of our process, but it's not the only thing.

In this case, it's just a fairly bland fund that we rate Neutral, not because we think it's going to blow people up, but just because we think the upside is fairly limited.

Benz: Another fund that hits the list of strong parent, don't like the fund quite as much, is American Funds Bond Fund of America. It's not a Negative rating, but it is a Neutral. Let's talk about why the conflict there.

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Kinnel: That's right. We really like American Funds' stock funds, where they have separate managers running small sleeves of concentrated equity portfolios, but on the bond side they have managers operating separately, and there it seems to be a problem. It just has meant they're not always in sync, sometimes managers cancel out each other's bets, sometimes you end up with greater credit risk than they might want. And over time they've tried to make some tweaks, putting caps on different types of exposures, but it's really never gelled, and you could see that in the long-term performance.

Benz: Another fund on the list is Templeton Developing Markets, one of the oldest emerging-markets funds out there. We like Franklin Templeton reasonably well as a parent company, but this fund just hasn't measured up?

Kinnel: That's right. Templeton Developing Markets is really one of the pioneers in emerging markets. You think about Mark Mobius, and he was once really synonymous with emerging markets, and it's kind of a shame, but the fund really hasn't evolved. Its expense ratio remains high, and they've got analysts all over the place, but collectively they just haven't produced very good results. You see that in the long-term performance. Over time Templeton has seen some key departures in managers. And so you have a pretty good parent and some good ideas there, but unfortunately it just really hasn't come together.

Benz: Another emerging markets fund illustrates the flipside situation. It's actually a fund we like a lot. We're not quite as enthusiastic about the parent company. Let's talk about Oppenheimer's emerging-markets fund?

Kinnel: Oppenheimer Developing Markets is run by Justin Leverenz, and he's just done an outstanding job. Oppenheimer has had some issues in their fixed-income areas, but their foreign equity is a really strong group that you don't want to pass up just because the overall firm has had some issues.

Leverenz has done a really good job looking for quality growth companies, and he's recently closed the fund because it topped $30 billion in assets. So, you can't get it now, but it's a great example of where you shouldn't just pass over a fund just because the overall parent had some issues. Sometimes you find some really strong pockets even in weak fund companies.

Benz: So, you mentioned that Oppenheimer had some issues with their core bond product, and I guess that's a question that investors might wrestle with: If the firm has had trouble in this one part on the shop, but it's maybe not at all related to the part that I'm interested in, how worried should I be about that? How should investors approach that decision?

Kinnel: It's a complicated question. I think part of it has to do with, do the problems that surfaced, in this case, in the bond area, do they apply here?

So, for instance, if there were some ethical issues at the top of the company, then that might go down to all of funds and give you a worry there. But I think in this case, the issue is more that they had some very high-risk bond funds and that's really never led to many issues on the foreign-equity side, where turnover among analysts and managers have been fairly low and performance has been consistently strong.

Benz: Let's discuss one last fund, Russ. This parent company actually earns a Negative rating from our analysts, but we still like the fund. Let's talk about what fund it is and what fund company it is?

Kinnel: Dreyfus Appreciation is a fund that's sub-advised, and sub-advised is another example of the kind of funds where sometimes you see an individual fund that might be fairly different from the fund company as a whole, because they have their own culture and they may be thriving while the parent is not doing so well, or the other way around.

In this case, you have Fayez Sarofim out of Houston running a very high-quality, low-turnover--the turnover is so low, it's lower than most index funds--equity strategy, and they've been very consistent, looking for strong franchises that really dominate their industries.

Over the long haul, they've done very well, and the issues that Dreyfus the parent company has faced over time really have never had any effect on the way the fund is run. It's never really affected the way people working at Fayez Sarofim have regarded the firm, and so it's really a good example of one where, again, you have a really strong fund that hasn't really been affected much by issues at the parent company.

Benz: I know Bridget Hughes, though, noted in her recent Analyst Report that she would like to see the expenses come down a little bit. That is something that Dreyfus could do for the fund to make it look even better.

Kinnel: Exactly. The parent is still an important part, and that's part of it--they do have some say over the fees, and so I would love to see the fees at that one come down. I mentioned its turnover is lower than index funds; its expenses aren't.

Benz: Russ, thank you so much for being here to share your insights.

Kinnel: You're welcome.

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