When Medalists Disappoint

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Morningstar analysts expect that their medalist funds will outperform over long periods of time, but they sometimes look underwhelming on a short-term basis. Joining me to discuss some funds that recently have disappointed on the performance front, but that we still think are great long-term picks, is Russ Kinnel. He is director of manager research for Morningstar.

Russ, thank you so much for being here.

Russ Kinnel: Glad to be here.

Benz: Russ, you and I were recently talking about Royce Special Equity. You said you get questions a lot from readers about why we still really like the fund despite the fact that when you look at its performance, it hasn't looked particularly spectacular recently. Let's talk about that. It's conservative-minded, that's part of it, right?

Kinnel: That's right. Even its longer-term record, if you look out 10 years, it's not very impressive. But there's still a lot to like. What I like is that it is a really conservative fund. It's a different fund. It's got some nice diversification qualities. Charlie Dreifus is looking for companies with really good accounting, clean balance sheets, and really is very picky about what he buys. The fund has consistently gained on its competition in down markets by losing less, but in really strong bull markets it's actually typically lagged. Given that we are about eight years into this bull market, the current trailing return periods don't look so good. But I still have faith because he is doing what he has always done, and I think there is a lot of value in that.

Benz: Small value funds as a group have been pretty disappointing recently, and this fund in particular has not looked great relative to other small value funds. One thing I wanted to touch on is the fact that there was the addition of an assistant portfolio manager recently. Does that clear up, I know there were some succession concerns on the team with this particular fund. We love Charlie Dreifus, but we're a little bit worried about what the next phase of the fund would be.

Kinnel: That's definitely one issue going forward is, Charlie Dreifus is already into retirement age. Certainly, you have to figure in at some point he will retire. But now, we at least see the clear successor, and I think we expect the strategy to continue. Of course, when you have a transition like that, there's always the question of will the new manager execute as well as the previous manager. Obviously, that's hard to know for sure, but he has had a long time to study with Charlie and really understand the strategy.

Benz: And it's a very accounting-intensive process …

Kinnel: Yeah, which is what I love. It's really different from a lot of other funds. Dreifus really digs into accounting and really gets to know all the companies and really avoids any companies with red flags in the accounting. To me, that's something different from what a lot of other funds have done, at least the extreme emphasis on that. Obviously, everyone looks at the books, but I think to a greater degree at this fund.

Benz: Another fund that I think fits the conservative mold well and hasn't looked so great recently is the Bronze-rated Dreyfus Appreciation. That's a large-cap fund, a very large-cap fund. Let's talk about that one and how investors should approach that fund and maybe not spend too much time worrying about near-term underwhelming results?

Kinnel: That's right. This is another one that you look at total return and you think why would make that a medalist, it really doesn't look impressive. There's a couple of reasons. One is, it's got a quality bent, and quality tends to do well in recessions because they are well-capitalized companies with good brand names. They hold up much better in down markets. Again, we haven't had a down market in a long time. Another problem is that the fund does have meaningful energy exposure and obviously, energy in the last few years has been pretty awful. Oil prices have rallied a bit. So, maybe it's not quite so bad today, but still, that's another headwind for the fund.

Benz: This is a fund that has very low turnover, right? It tends to stick with ...

Kinnel: Super patient, single-digit turnover, which again we really like. It's a dependable fund. The fund five years from is probably going to look a lot like it looks today. I think that's really great. But again, it doesn't look all that impressive today.

Benz: It might earn its keep on the downside though. Vanguard Short-Term Tax-Exempt Fund, a municipal bond fund, short-term. When I look across the board at its trailing long-term returns, noting to write home about, certainly, but you say real value there is in the risk controls.

Kinnel: Exactly. This is a fund that's at the shorter end of its peer group. It's got less duration and that means lower interest rate risk. It's almost a money market substitute. It's got a little more risk than money markets for sure, but still much less risk than its peer group and obviously lower fee so it doesn't need to take much risk. But again, that pays off in the down markets, but also you can just use it appropriately. If you've got other muni funds with longer duration, it can offset that. Just a very conservative fund. Again, when interest rates rise, it's going to do better. When interest rates are declining, when the bonds are rallying, it's going to lag. That's just a given.

Benz: Royce, Dreyfus, and the Vanguard Short-Term Tax-Exempt, all conservative versions within their category. That explains their recent underperformance. The last fund is Artisan International Small Cap. It doesn't really fit with that mold of the funds that we've just discussed. Let's talk about what's going on there. It's a fund we like. We've got it with a Silver rating, but its results haven't looked that great recently.

Kinnel: That's right. And we can't blame its conservatism. It's really about as risky as the typical foreign small-cap fund.

Benz: Which is kind of a risky category to begin with?

Kinnel: It is. It is. If you look at the bear market from '08-'09, this is a category and this is a fund that really got smacked--lost about two-thirds of their value. So not low risk. But the reason here is more just quirkiness. It's a fund that's got over 70% in Europe compared to about 30% for the peer group. It's got less in emerging markets, much less in Japan. It's kind of just going to have unusual performance relative to the peer group. It's also got big individual stock positions. Just quirky performance. We still have faith because Yockey's very long-term record is still good, and we don't see where anything has changed. He is very good at closing the fund so that it doesn't get too big …

Benz: And it's currently closed to new investors?

Kinnel: Yes, so that gives us faith that he is still doing what he has always done. It just hasn't worked out. I wouldn't position this as a conservative fund. It just appears to be a good fund that's just had a bad streak.

Benz: Just to follow up on the closing comment. Royce Special Equity, I know that's another one that's been closed on and off over the years. Where is it now?

Kinnel: It's open today.

Benz: Open to new investors. Russ, always great to hear your insights. Thank you so much for being here.

Kinnel: You're welcome.

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