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Lessons From Two Market Cycles

Russel Kinnel
Christine Benz

Christine Benz: Hi, I'm Christine Benz for How have various funds performed over two full market cycles? Joining me to discuss some recent research on that topic is Russ Kinnel, he is director of manager research for Morningstar.

Russ, thank you so much for being here.

Russ Kinnel: Good to be here.

Benz: Russ, in the November issue of Morningstar FundInvestor, you took a closer look at how various funds in the Morningstar 500 have performed over the period from 2000 through 2016 to-date. So, you looked at sort of end-to-end performance. Let's start by talking about what is the value of that exercise, of looking back beyond, say, the trailing 10 or even 15-year periods.

Kinnel: Yeah. So, as you pointed out, these numbers aren't in your 10-year numbers which means they are not in the star rating. But of course, the previous bear market was a very important event and fairly different in the way it worked than the more recent bear market. So, I think, it's a way of saying, what if you have used two full market cycles, two bear markets, two bull markets, to really see how has the fund added value, how has it done on risk because it's had to go through two very hard bear markets.

Benz: OK. So, you looked at the funds in the Morningstar 500, but you also looked at the subset of those funds that have had managers who have been on board for that whole time period?

Kinnel: That's right. I wanted it to be as meaningful as possible. So, managers who are there through the whole period, I think, is where it's going to be most telling.

Benz: So, one thing you looked at was within various categories you looked at how the active funds have performed relative to a good core benchmark within that category. Let's take a closer look at the large growth category. The interesting finding that you point to is that even though say, Vanguard Growth Index looks very, very strong on a trailing return basis over the past 10, five, 15 years, that there were a number of large growth funds, actively managed large growth funds, that actually beat that benchmark over this time period that encompasses both bear markets. Let's talk about that general finding, why you think that is and why you think maybe those stronger bear market returns for active funds are perhaps getting a little bit obscured by the trailing returns that we see?

Kinnel: That's right. Right now, large growth active managers are really under fire because so few have been beating the large growth indexes. So, it's really a tough time for them and you look at them and say, well, are they really adding value? And yet, if you step back and add in this further time period with that earlier bear market, you see that in fact quite a few actually have added quite a bit of value if you look at it on either a total return or a risk-adjusted basis. That earlier bear market was one of the all-time big meltdowns for large growth because we had so much tech speculation that it was kind of the textbook example of price risk. Even though many of those tech companies actually grew pretty well after that period, they were priced so high that they couldn't possibly live up to those expectations. And so, it's really an important time period for assessing growth managers.

Benz: OK. So, looking at the best performer over this specific time period on a raw return basis, that's Vanguard Capital Opportunity. We'll just say right off the bat that that fund is closed to new investors. But let's talk about what you think worked in its favor over this specific time period.

Kinnel: Yeah. So, I think, a couple of things worked in its favor. One is, it's a fundamental-driven growth process. And if you look at many of the leaders on this list, they are fundamental-driven, and by that, I mean, they don't just chase performance, they don't just chase momentum stocks. And that was obviously particularly important in that previous bear market, that the funds that really bought into all the dot-com hype got crushed. Those that stayed grounded to fundamentals, paid attention to valuation even though they are not super low valuations, came out much better. Vanguard Capital Opportunity's strategy is very much a one to counterpunch. That is, if growth stocks they like are getting beat down, they will buy then as opposed to buying after they've had a big rally and you see its total returns over that full time period nearly doubled the Vanguard Growth Index funds' returns.

Benz: OK. So, this fund we mentioned is closed to new investors. Are there prime-cap managed funds that investors can buy at this date? I know a number of them have closed over the past years.

Kinnel: That's right. So, the funds they subadvise for Vanguard are all closed. But under the prime cap label, they still have PRIMECAP Odyssey Stock and Odyssey Growth are still open to new investors. And they are fairly comparable to Capital Opportunity. So, still worth a look.

Benz: OK. Within this research you also took a look at a statistic called Sortino ratio. So, you computed Sortino ratios for various funds and in various categories over this specific time period. Let's talk about what Sortino ratio is and what it does that, say, our star rating doesn't do.

Kinnel: Sure. So, it's another risk-adjusted return measurement, not too different from the Star Rating except that the star rating is only three, five, and 10-year periods. The Sortino, you can run on custom time periods like the one I've chosen here. Other than that, it's not load-adjusted, but it's pretty similar and most of the risk-adjusted measures you have, they have slight differences but they give you pretty much the same answer.

Benz: OK. So, Vanguard Capital Opportunity, we said was sort of the raw return winner over this time period. When you factor in risk and volatility, the best performer there on the basis of Sortino ratio is Jensen Quality Growth. Let's talk about that fund.

Kinnel: That's right. This is a fund where its value-add on the risk-adjusted returns is probably more so on the risk side than the return side because they have a focus on high-quality names, and high-quality names tend to be very good defensive stocks. So, in downturns, they are going to hold up better. So, that's what this fund's core strategy really is. It's a concentrated portfolio of high-quality names. Generally, it's a good way to add defense. Obviously, some large growth funds are much more about offense and much more of a high-risk, high-return strategy. This is more a little lower risk but still has delivered quite a nice experience to investors over those two full cycles.

Benz: OK. So, you examined performance for a variety of categories over this time period in the FundInvestor article. But let's talk for just a second about large growth specifically. You mentioned that the managers are really under pressure. One thing we've seen is this mass exodus from large growth funds. When we see the categories that are losing assets, it tends to be within large growth. What's going on there? Is that investors are just maybe moving to some of the core passively managed funds that live in the large blend category? Are they giving up on large growth altogether?

Kinnel: Yeah, it's interesting. I think you nailed--the biggest thing is a move from active to passive, is probably the biggest driver. I think also some people never really came back to growth after that 2000 to '03 bear market, or '02 bear market. So, I think, that's part of it. Then on top of that right now, as we mentioned, there's a really high bar that the index is putting out. And the reason for that is that a number of the top tech names--Facebook, Apple, Netflix, Google/Alphabet--have for the most part been very good performers. And when those top names do well, it's tough for the active funds to do well because the indexes themselves are cap-weighted. So, they have got a pretty heavy weighting.

So, let's say, you want to make a bet on Apple outperforming versus your benchmark, maybe you have to put 7% or 8% in there. So, when the really mega cap growth names dominate, the index is going to dominate. Now, it will flip around, of course, if, say, small value starts to dominate because the typical active large growth fund is going to be less pure than the index. So, right now, we are at low ebb and this exercise shows that it's not quite as bleak as that. But for sure, growth managers need to deliver a better experience.

Benz: OK. Russ, interesting research. Thank you so much for being here to share it with us.

Kinnel: You're welcome.

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