Inside Morningstar's 401(k)

I like knowing where fund managers put their money: It's a true test of what they have faith in. In the same vein, I'm aware that our readers like to know what's in Morningstar's 401(k) plan.

We recently added more funds to our lineup, so this is a fine time to update you about our choices. In our 401(k), we seek low-cost funds that make great long-term investments. I sit on the committee that selects the funds, and we have free rein to select virtually any fund. We look for the absolute lowest-cost share class available on a fund. Period. In contrast, many 401(k) plans seek funds with 12b-1 fees, or fees from the plan provider, in order to put the administration costs onto employees.

Some of the share classes mentioned are institutional and might be difficult for you to access, but nearly all have reasonably priced retail share classes that are on our Analyst Picks list. For the three PIMCO funds, Harbor offers the cheapest retail share classes. Allianz NFJ Small Cap Value PSVIX is closed to new investors, and Morgan Stanley U.S. Real Estate MSUSX is only for institutional investors.

There's a natural lag in making lineup changes--we have to review replacements, make a decision, inform the plan administrator, and then the administrator has to implement the changes. Because of that, we place extra emphasis on stability of management and strategy. We want funds that we are confident will continue to be good investments for a long time.

We intentionally build in some overlap on the investment-option roster with the idea that we want the plan to work for different goals and preferences. The lineup isn't designed for employees to own every fund.

On this go-round, we added some funds that round out our income exposure. As our workforce gets a little older, we need more bond options and also ways to hedge the damage that inflation can do to those bond funds. Here, then, are the new additions. I'll cover our foreign-stock lineup in a column next year.

 PIMCO Commodity RealReturn Strategy (PCRIX)
The more you have in bonds, the more important it is that you hedge away some inflation risk. This fund tracks commodity prices with a Treasury Inflation-Protected Securities overlay. If you have a lot of high-quality, long-term bonds or bond funds, you have some meaningful inflation risk. This share class charges only 0.74%, but Harbor Commodity Real Return Strategy HACMX is actually the cheapest version for individual investors. It is run in a tax-inefficient way, so it is best held in tax-sheltered accounts.

 Loomis Sayles Bond (LSBDX)
This fund rounds out our bond exposure with a flexible approach that includes foreign bonds, high-yield, and high-quality bonds. Managers Dan Fuss and Kathleen Gaffney move among bond asset classes. It's great but definitely high risk. The risky side cost the fund a 21.8% loss in 2008, but it's up 36% so far this year. I plugged the fund as a great play earlier this year, but the rally has been so strong that it's not nearly as timely a buy now.

 T. Rowe Price Short-Term Bond (PRWBX)
We also beefed up the cautious end of our bond lineup. The more you have in bonds, the more you need to broaden your exposure to different durations and credit risk. In a taxable account, short-term bond funds are logical as the next place to tap after you've used up your money market. In a 401(k), they are particularly useful when you are withdrawing money.

 American Funds Washington Mutual (RWMFX)
We weren't just thinking bonds when we thought about income. We have a dividend-focused small-cap fund and wanted a large-cap choice, too. Dividends are something of an obsession at American, so this fund seemed like a natural choice. Lest someone accuse us of chasing performance, dividend-oriented funds, including this one, have had a hard go of it since the financial swoon. Still, the fund has lasted through numerous prior crises and delivered good results. We also liked the fact that the fund's dividend discipline--it can only buy stocks that have paid dividends in nine of the past 10 years--ensures that it remains firmly in the value camp. Two of our other "valuey" funds, Selected American SLASX and Oakmark Select OAKLX, have a mix of blend and growth that makes them behave a little more like the S&P 500 and less like traditional value funds and their indexes. This is about as cheap as this fund gets. The R5 share class charges just 0.37%, though the A shares' (AWSHX) 0.65% expense ratio is pretty reasonable, too.

Here's the rest of the lineup:

 Allianz NFJ Small Cap Value (PSVIX)
We introduced you to this gem when it reopened in 2008, but it closed again earlier this year. We like this fund's disciplined dividend approach, but we're happy that it closed because it's a beefy $6 billion.

 Brandywine (BRWIX)
Brandywine is a momentum fund that's driven by human intelligence rather than computers. Analysts work the phones and get on airplanes to gather information about sales trends so that they can correctly call a company's next quarter of earnings. Sometimes they make the fund look incredibly nimble, as when they rode the tech boom in 1999 but hopped off in time to limit losses in the following bear market. Yet they are flailing away this year as the market's rotation has worked against them. Over the past 20 years or so they're ahead of their benchmark, but the periodic air pockets are tough.

 Harbor Capital Appreciation (HACAX)
In many ways this is a typical growth fund. It seeks out promising companies with strong growth rates and avoids paying an extreme price for that growth. However, everything is just a little better than what you see at most growth funds. The team goes deeper, is more experienced, and does more and better fundamental research than is typical. Likewise, there's greater discipline to the approach when it comes to sector risk, debt, and valuations. Manager Sig Segalas has whipped his benchmark since taking over in 1990, only no one's paying attention because large growth has had such meager returns in recent years. But when growth comes back, people will be all over this fund.

 Morgan Stanley U.S. Real Estate (MSUSX)
This is an outstanding institutional fund, but it's not easy for individuals to gain access to it because it has no retail share classes.

 Oakmark Select (OAKLX)
We've had Bill Nygren's mutual fund in Morningstar's 401(k) for more than a decade. That means we've been there through thick and thin. Although I'd like to see it lower expenses a bit, this mutual fund is back in the thick. It outperformed on the downside last year and has an excellent 49% gain so far this year. Nygren's returns from the 1996 launch of the fund were always ahead of the S&P 500's, and that gave us confidence to stick with him even as he suffered a long bout of poor performance.

 PIMCO Real Return (PRRIX),  PIMCO Total Return (PTTRX)
The first is a TIPS fund, and the second is a wider-ranging high-quality bond fund. Both highlight a great bond shop's expertise. With the bond market settling down, these core holdings look particularly attractive.

 Primecap Odyssey Aggressive Growth (POAGX)
This is the best mid-growth fund, hands down. The Primecap team is one of the best growth teams around and you get it for just 0.78% in expenses. The fund has only $390 million in assets. In the past and so far at this fund, Primecap has shown that it can do great things with that kind of flexibility.

 Selected American (SLADX)
You know this story. Great value investors in the Buffett mold. The fund has also lowered its expense ratio to 0.59%.

 T. Rowe Price High-Yield (PRHYX)
Manager Mark Vaselkiv is an excellent manager who has led this fund through two credit meltdowns. He consistently puts up strong returns yet maintains the diversification needed to tone down risk.

 T. Rowe Price Small-Cap Stock (OTCFX)
Right around the time that Allianz NFJ Small Cap Value was closing, T. Rowe Price reopened this fund. The fund had been closed for five years, but the bear market brought it down to around $3.5 billion and now it stands at $4.6 billion. It's not an exciting fund, but it is dependable. Manager Greg McCrickard has done a nice job of blending value and growth stocks into a diversified portfolio. The mutual fund tends to produce a lot of second-quartile returns. McCrickard looks for steady and cheap companies, and he keeps turnover low.

 Vanguard FTSE Social Index (VFTNX),  Vanguard 500 
They're supercheap, and they're due for a rebound after a decade in which mega-caps were laggards.

 Vanguard Selected Value (VASVX)
This mid-value fund has been the portrait of consistency. It has outperformed its peers in eight of the past nine calendar years. Jim Barrow and Mark Giambrone of Barrow Hanley run about 70% of the portfolio in a deep-value-focused style. Donald Smith runs the rest of the money in a deep-value style, too, though he will sometimes allow cash to build on his side. When a Vanguard fund puts up top-quartile performance over the trailing 10 years, it tends to get noticed. Fortunately, this fund still has a modest $2.9 billion in the till.

This article originally appeared in the October issue ofFundInvestor.

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