Time to Rebalance Into Large and Low-Volatility Funds

Christine Benz: Hi. I'm Christine Benz for Morningstar.com. Equity markets have been on a tear so far in 2013. Joining me to discuss some of the key success factors influencing fund performance is Shannon Zimmerman. He is associate director of fund analysis with Morningstar.

Shannon, thank you so much for being here.

Shannon Zimmerman: Good to be with you, Christine.

Benz: Shannon, investors, when they open their statements at the end of the year, probably will see some really good numbers, positive performance across the board. But when you drill into it a little bit more, you do see that having certain style tilts, for example, in a portfolio would have been extremely beneficial.

Zimmerman: Absolutely.

Benz: So the big one is small versus large. When people open their statements, if they have  small-cap funds or even large-cap funds that emphasize smaller large caps, that's been a big plus.

Zimmerman: Yes, that's a good point about emphasizing small caps even within a large-cap category because you're exactly right. In all categories, the smaller a fund has been, the better the performance has been. It is going to be happy holiday season for everyone in absolute terms because across the board, equities have really powered ahead. But exactly right, small-cap funds and those that favor smaller-cap stocks within the diversified categories, as we were saying, have been the most dramatic outperformers.

There's been a slighter advantage to growth versus value, too, but so far in 2013, and now we're in November now so we can come to some conclusions, it looks like small-cap is going to be--in terms of style attributes--the dominant factor that is associated with success in this year.

Benz: You say there are some other factors, though, that have contributed to under and outperformance. Another big one in your view is volatility; the extent to which a fund does or does not embrace higher-volatility stocks has been really influential.

Zimmerman: It absolutely has. Just in terms of as an investor and as an analyst, I really think that it's unfortunate that risk has become a pseudonym for volatility because risk to me is really the risk of capital impairment, permanent capital loss. However, risk as volatility has been a major factor this year.

A couple of years back, Standard & Poor's rolled out low-volatility and high-beta versions of the S&P 500, and there are now a couple of PowerShares exchange-traded funds that are based on them. This year the PowerShares ETF that is high-beta--it tracks the S&P 500 High Beta index--has dramatically outperformed the low-volatility ETF. The margin of victory for the high-beta version is about 10 percentage points.

So you look at the universe of mutual funds, and sure enough, the funds that have higher beta--that's the volatility of the fund relative to an index--has been a factor almost as powerful as market cap has been in terms of small cap outperforming large cap.

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Benz: Momentum, you say, is another factor here. Momentum had underperformed so badly for so long. I think a lot of people have given up on it, but you say it's actually been a pretty powerful force so far in 2013.

Zimmerman: It hasn't had a shoot-out-the-lights year, but it has had a very strong year. So AQR Momentum is about the purest play in terms of mutual funds on price momentum. As we were talking before the segment began, I really am a fundamental investor in my own portfolio and primarily as an analyst. But price momentum is fascinating, and it should be to fundamental investors because it has worked over a very long period of time. So yes, this has been in a way a middling year for AQR Momentum. It's in the 40th percentile of the large-growth category, but still over a 30% return indicates that price momentum, just a plain and simple strategy, has done quite well this year.

I want to take us back if we could to the low volatility versus high beta discussion. This year it has been a case that high beta has dramatically outperformed low volatility in terms of the way the S&P indexes are constructed. However, over the very long haul, the opposite has been true. Looking at the vehicles that got rolled out to track these indexes, the high-beta version hasn't attracted much at all. The low-volatility tracker has done quite well in terms of asset gathering. I hope that persists because there was a paper in 2011 that looked at a 38-year time series and found that there was a low-volatility premium, just defining the volatility as standard deviation.

If, as we know from our research, investors typically aren't able to use high-volatility funds very well, and if as academic literature seems to show, there really is a low-volatility premium, that's a way that investors can have the best of both worlds--a portfolio that should do well if history is any guide over the very long haul and lets them sleep at night.

Benz: When you say investors have not used the higher-volatility funds well, what do you mean by that?

Zimmerman: Well, my poster-child fund for this is Fidelity Leveraged Company Stock, and that's a fund that over the last decade has [had a return of] about 12% annualized. But the typical investor in Fidelity Leveraged Company Stock--the mandate is baked into the name--has only gotten about 4.5% of that. So it's a huge, huge gap. In some ways you can kind of understand it because it's about ill-timed purchases of the fund whenever it's riding high, and then redemptions whenever it's not riding high, doing the opposite. In 2008, for instance, it lost about 54%, and then in 2009, exactly the kind of market you would expect it to do well in, it gained almost 60%, but investors didn't really enjoy much of those gains at all.

So that sort of raises into sharp relief a broader tendency of investors to not be able to use high-volatility funds very well. As I say, the history seems to suggest that there is this low-volatility premium, and if investors really don't feel that they’re going to have the stomach for a high-beta index tracker like the one that is now available through PowerShares, the low-volatility one might be a way to go.

Benz: So as investors are looking through their portfolios, seeing what has outperformed and what has underperformed, I think that these style factors can be very important in terms of understanding why things have performed as they have. But you say sometimes it doesn't break down along style lines. Sometimes you see a fund underperform or outperform simply because of the holdings in its portfolio.

Zimmerman: We usually slice the baloney too thin. Certainly at the end of the day, actively managed funds, particularly concentrated actively managed funds, all of the style analysis and the factor analysis that we’ve been discussing can be helpful, but sometimes you’re just swamped by good or bad stock-picking. So one example of a fund that I would call out is John Hancock U.S. Global Leaders Growth. It’s a fund that’s on my coverage list, and I like the fund. It’s a Bronze-rated fund, primarily because the expense ratios are a little higher than I would like them to be. Over the very long haul, it has quite a nice track record. This year, however, it hasn’t performed well at all, even though it’s among growth funds, which should have served it well. And it has a smaller average market cap than its typical peer, which also should have served it well just in terms of the cap-range dynamic that we were discussing earlier.

But it's fared very badly, primarily because of one name, Intuitive Surgical, that had badly missed revenue results in the second quarter, and the fund had a horrible second quarter. It’s pretty much matched the category average in other time frames within the year, but that one really just took the wind out of its sails. So it's now in the bottom decile of the category as a result of, not the style attribute, but a stock pick that went awry.

Benz: So with concentrated funds, a lot of times it just comes down to good or bad stock-picking.

Shannon, this is also the time of year where a lot of investors reallocate funds and do some rebalancing. As they are thinking about their portfolios and sort of looking at their winners and losers, do you have any guidance for people in terms of how they allocate new capital.

Zimmerman: Buy the unloved, right. If you rebalance into parts of the market that are undervalued, and if you're a patient long-term investor, that should pay off over time.

Benz: So that would mean this year maybe [rebalance a] little more into large caps and…

Zimmerman: [And the value category] on the margins.

Benz: And maybe some of the low-volatility strategies.

Zimmerman: Exactly. The assets, I think I had mentioned that they've raised about $4 billion in the low-volatility index tracker, so maybe they'll persist and grow a bit.

Benz: Shannon, thank you so much for being here.

Zimmerman: Good to be with you.

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