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Our Active and Passive Picks for Bank-Loan Funds

Christine Benz

Christine Benz: Hi I'm Christine Benz for Bank-loan funds have been generating a lot of interest lately. I sat down with Tim Strauts and Sarah Bush, two of Morningstar's bank-loan fund specialists, to discuss some of Morningstar's favorite picks within the category as well as some fund types to avoid.

There has been so much interest in the bank-loan category. I'd like to talk to you two about some of Morningstar's highest-conviction bank-loan investments, both mutual funds and exchange-traded funds.

Sarah, let's start with you in terms of the open-end bank-loan funds that we look at, what do you rate as our highest-conviction pick in that space?

Sarah Bush: We have a Gold Morningstar Analyst Rating on Eaton Vance Floating Rate, and this is a very experienced management team. It's been in the market for a long time, backed by really serious, good analysts. This is kind of a market-rate-like fund. This particular one doesn't carry any leverage, which some of the other Eaton Vance products do. We just really like the research backing it, and we feel like they're taking a careful and cautious approach to the risks in the market.

Benz: Eaton Vance has been a big player in this space for a long time. They have several different funds, but this is your top pick.

Bush: Yes. Eaton Vance Floating Rate, which is their pure, or nonleveraged, bank-loan fund.

Benz: Tim, let's talk about the exchange-traded fund space. There's been an explosion of interest there, as well. In terms of Morningstar's favorite pick in the bank-loan ETF space, what is the top-conviction fund?

Tim Strauts: It will be PowerShares' Senior Loan, ticker BKLN, and this is an index portfolio. Typically most bank-loan funds are very active in nature, but this fund owns an index of the 100 largest bank loans in the market. You get a very diverse collection of loans and typically speaking, the 100 largest are also going to be the 100 most liquid. You get a more liquid, not necessarily high-quality, but big size as far as bank loans.

The fee in the fund is pretty low because it's an index fund. It's 65 basis points, which may sound high if you're in most ETFs, but compared with most of the bank-loan funds, it's pretty cheap. And it has also grown to about $5 billion in assets just in the last two years.

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Benz: A related question is sometimes investors might look at a category like this and think, "I would like an active manager here." How do you weigh that active-versus-index decision in the bank-loan space?

Strauts: What I would say is that the bank-loan space is a very illiquid sector, so there is more opportunity for active management in this space. But many people who are accessing bank loans are not necessarily going to be invested for the next five or 10 years. They are looking for a tactical play based on what's going on in the market today. And that's oftentimes when an ETF makes a lot of sense, where you're making a bet on where interest rates are going to go and the more liquid ETF is the place to be. And you don't necessarily want have to deal with the manager and his active bets. You're just trying to get access to the market. That's where the ETF makes the most sense.

Benz: Sort of a low-cost, pure play on that market sector. It makes sense.

Bush: Right. And I would just add to that, and we certainly think this is a sector where there is more potential for active management to add value. And then also to Tim's point, if you do want to [buy and sell] in and out [of the funds], a lot of the actively managed funds have back-end loads on them, so obviously not something you can do [about that] there.

Benz: Sarah, Morningstar analysts have another medalist pick in the open-end bank-loan space, that's a Fidelity fund. It's one that had a manager change recently, but the team still likes it. Let's talk about that fund.

Bush: Sure. It's Fidelity Floating Rate High Income, and this is a fund that we [assigned a Morningstar Analyst Rating of] Gold for a long time. There was a manager change, so it now has a Bronze rating. But we really do have a high-level conviction in that Fidelity high-yield and bank-loan research team which is behind a lot of other funds that we like. And this is an interesting fund because it really doesn't land at the conservative and in terms of credit quality of the bank loan market.

It still has credit risk, but it really is kind of geared at the higher end in terms of credit quality of the market, and that served it very well in 2008 and other bumps in the market. For folks who are looking for a little bit more of a way to dip their toes in the market, this is a good fund with which to do that.

And that actually brings up another point, Christine, which I think is important as investors look at these funds. Especially in this market where you've seen just a ton of interest in funds flowing and you're not getting paid by historical levels a ton for credit risks, be careful about the funds that offer the highest yields or have had just the best performance over the last couple of years. Some of them have leverage where you might be taking on a lot more credit risks.

You really need to make sure you have the stomach for that type of investment, which could sell off fairly dramatically if we have a big backup in the credit markets.

Benz: Know what you own and make sure it's a good match for you as an investor.

Bush: Right, as always.

Benz: Tim, any cautions from you in terms of investors navigating this space, especially in the ETF area?

Strauts: Yes. You want to own a fund that has a large amount of assets, kind of like the fund just recommended. [I think the big caution here would be is] there are several new bank-loan ETFs that have less than $100 million in assets and trade fewer than 100,000 shares a day, and those are not a product you really want to be invested in, where the flows can turn pretty rapidly. You don't want to have the risk of wanting to sell your fund and there's no one to buy it because the trading volumes are so low.

So in general, I'd say you want to stick toward the larger funds.