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Can Stock Funds Continue Their Rally in 2013?

Morningstar's Shannon Zimmerman recaps this year's equity-fund runup, noting the double-digit returns, the investor migration to passive products, and the trends in international categories.

Christine Benz: I am Christine Benz for Despite concerns about the impending fiscal cliff, stocks have actually enjoyed very nice gains so far in 2012.

Joining me to provide a recap of equity-fund performance so far this year is Shannon Zimmerman. He is associate director of fund analysis with Morningstar. Shannon, thank you so much for being here.

Shannon Zimmerman: Very good to be with you at the end of the year.

Benz: Shannon, it's been a year where the market has really lifted all boats. When we look across stock-fund performance, what we see really is double-digit gains across the board. I'm wondering, when you drill in a little bit, if you look at, say, large caps versus small caps, do you see any gradations there?

Zimmerman: It's more subtle than in some market environments where the differences between small cap and large has been quite huge. This year though--and we talked about this earlier in the year too--one pattern that has persisted is that it has been better to be bigger.

So, larger-cap funds have generally fared better than smaller-cap funds. The best-performing category in the year--and it really was kind of neck-and-neck--is mid-cap value. But the second best-performing category is large growth. And the smaller-cap diversified categories are all toward the back of the list in terms of performance year to date. But as you say [it has been] a really fine year in absolute terms. All the categories on the domestic-equity side--the diversified and the more narrowly tailored funds--are up double digits.

Benz: How about the growth-versus-value spectrum. Do you see any gradations there?

Zimmerman: Not so much, in terms of the valuation spectrum. The patterns that we saw earlier in the year where growth was trumping value, that's kind of faded away. It was subtle to begin with, and now it doesn't exist at all.


Benz: How about when you look at sector-fund performance or how sectors have driven fund performance. What are you seeing? What the top-performing equity-fund sectors for the year to date?

Zimmerman: Well, the more cyclical sectors have done best, which is somewhat surprising. It doesn't really feel to me like it was a risk-on year so much, but when you look at the performance of the various sectors, the ones that are more exposed to the economic cycle are the ones that have fared best. And the most sensitive names have not done as well. But still people are tilting toward risk in their portfolios.

Morningstar has developed indexes that track the target-date universe. And among those indexes, the Morningstar Aggressive Target Risk index has done the best. Again, it doesn't really feel to me like this has been a dramatically risk-positive environment. But yes, when you look at the data, it seems that investors have tilted that way.

Benz: I know we want to keep the focus on equity funds, but we've noticed that in the bond space, as well, correct, where investors are in risk-on-mode in a sense?

Zimmerman: Well, that's exactly right, and in a couple of ways, too. So, this year has really been a rewarding one for the riskier fixed-income categories, such as high-yield emerging-markets bond and long-term bond. Those are the ones that have done the best. You look at the data--and folks continue to stampede into fixed income--but in a way there is a portion of those assets that also reflects a risk-on move because it's not as though they are yanking all the money from equity funds and putting them into fixed-income funds. A good chunk of that money is coming out of money market accounts, too. So, even a move into a more plain-vanilla fixed-income category, such as intermediate-term bond, could be a risk-on move relative to a money market account where those [funds for investment] were sitting.

Benz: Right. Let's talk about equity-index fund performance versus actively managed funds. I know we could do a whole segment on this because it's such a huge topic. But what's the headline there in terms of how the active managers have done versus those big benchmarks like the total market indexes or the S&P 500?

Zimmerman: Well, it's been a tough time for active management. Generally, in terms of asset flows, the people are stampeding not only into fixed-income vehicles but into passive vehicles, as well. And then among large-cap and mid-cap funds, it's been a tough year for active mangers versus the typical benchmarks. So, the typical mid-cap blend fund has lost to the S&P MidCap 400, which is a very tough-to-beat benchmark anyway but has not been a good index this year for mid-cap blend managers. And the same is true for large-cap blend managers. They on average have not beaten the S&P 500, which is the standard benchmark for those funds typically. So, that's been a bad year in terms of active management stacking up against the indexes for large- and mid-cap funds. However, that's not true for managers who are benchmarked to the Russell 2000. That is a fairly easy-to-beat [index].

Benz: Historically, it has been, yes.

Zimmerman: Yes, exactly. The managers love it when they are benchmarked to that. The S&P MidCap 400 not so much. But even there, typically you would see a wider performance gap between the active management and passive. Not so much this year. Really the typical active manager in the small-cap blend category is just edging past that benchmark.

Benz: Now, I want to drill in on a couple of specific domestic-equity funds. Both of them have been nominated for a Fund Manager of the Year award in that category. One is a BBH fund. Let's talk about that fund and why it has done so well so far in 2012.

Zimmerman: Well, so BBH Core Select is the fund, and it's done well in two fairly remarkable ways, both in terms of performance, but [it has been] a good year for equities. It's also done quite well in terms of asset growth. So, it's gained about $1.9 billion over the last 10 months during a period where people have been fleeing actively managed mutual funds. [The fund has] done it quite well.

The other thing that's terrific about this shop and its approach--and it's a bank-run mutual fund and we don't typically think "Oh, well it's a bank-run mutual fund, so this is going to a fantastic vehicle." Typically, there is a captive audience and the asset management part of the bank is not really that great.

Benz: It might be OK, but not particularly distinguished.

Zimmerman: Exactly. So, this is bank-run mutual fund, but BBH is a different kind of bank. It's more of a partnership, and they are really quite protective of current shareholders and their funds. And so it's a large-cap fund. It's rather concentrated with about 30 names; about half of the assets in that fund are in just 10 of those names. So it is concentrated. But they closed a large-cap fund at just $3.5 billion. And they preannounced the close and the level at which they would close the fund, and that's rare.

Benz: That's small. It sounds large, but that's a small hurdle for a fund to close, a large-cap fund.

Zimmerman: Exactly, right. So, the mangers are investing in high-quality, highly-liquid names and so $3.5 billion in terms of the funds that we cover in that world, that is quite small. But as I say, BBH is quite protective of their current shareholders, and so they soft closed. It's not a hard close. Current shareholders are still permitted to invest new dollars, but at that level there is plenty of capacity for BBH's strategy irrespective of how concentrated the fund is.

Benz: Another fund you wanted to discuss is American Funds New Economy. That's sort of the opposite story. Like all the American funds or many of the American funds it's been seeing big redemptions, but it still has managed to post very nice number so far.

Zimmerman: Yes. It's sort of a sad story there because these guys are doing great work. And it sort of underscores the importance of the prospectus. Everyone should read the prospectus. I don't know how many are stacked upon the night tables. But sometimes prospectuses are written in just a bland and overbroad language that seems to be permitting just about anything.

[American Funds] actually had a shift in mandate last year that did kind of open up some of the horizons for them to invest in other parts of the market, and it has been a good development for them because this year they were able to take advantage of that flexibility and did quite well. [The fund has] a talented management team, with five managers who on average have been at the helm for about 14 years. They've done nice work over the long haul, and they had a terrific year this year, as well. It just kind of underscores the significance of what seems to be a small kind of lawyerly change in the prospectus having some implications for the portfolio and for the way the managers pick stocks. That really worked out well this year.

Benz: Let's quickly talk about some of the headlines in international-fund performance so far this year. Let's talk about the leading categories. In general, it looks like at least through sort of late December, international funds are even doing better than U.S. funds.

Zimmerman: Right, and we were talking before we started filming this segment that it's such a nuanced thing. So, we are looking at data from Dec. 10, and "Well, it looked like domestic equity was doing better." As of [Dec. 19], you're exactly right; it looks like the international categories are doing better. But as with the U.S. side, it has been a good year for investors internationally, as well. The worst-performing categories, Japan stock and Latin American stock, are also up. Not quite double digits, but close to it. So, it has been a good year to be investing both here at home and abroad, as well.

The pattern that we see on the U.S. side in terms of large cap trumping smaller cap, that doesn't really look to be the case so much on the international side. You don't want to slice the baloney too thin, and there aren't huge gradations between the performance of the categories. But on the international side, smaller has generally been better than large.

Benz: India equity is so far the top-performing category year to date. But one I wanted to highlight is Europe, because I don't think coming into 2012 a lot of investors had very great expectations for Europe, and yet it has been a very strong-performing category. What do you think is driving that?

Zimmerman: It's kind of interesting, and in some ways it underscores the adage that volatility creates opportunity. And for managers who are active managers and are willing to go where investors are fleeing, it's really been quite rewarding.

One of the funds that I cover is Oakmark International, and David Herro has had an overexposed allocation to European financials and to commercial banks, but they are higher-quality banks, and they've done quite well. We were looking at couple of indexes that track European financials before we started this segment, and they are up over 30% this year. This really points to the disconnect that there can be between economic fundamentals and opportunities in the market.

In order to get stocks at a discount, you have to go where there's some trouble. And then you hope you do your homework right, and you pick the higher-quality names so you can have somewhat of a smooth ride. And then as over time those economic fundamentals get stronger, and they are improving--if only that the margins, the trajectory is headed in the right direction--then you are rewarded for taking the risk. That's the way that it's supposed to work, and this year it seems to be working just that way.

Benz: Shannon, thank you so much for providing a recap of what has been a very good year for equity-fund investors.

Zimmerman: Very glad to do it, Christine.

Benz: Thanks for watching. I am Christine Benz for

Christine Benz does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.