A Closer Look at Two Medalist Balanced Funds

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Although combination stock/bond funds rarely jump to the top of the charts, they tend to be easy to own. Joining me to discuss this topic is associate director of fund analysis Shannon Zimmerman.

Shannon, thank you so much for being here.

Shannon Zimmerman: Always good to be with you, Christine.

Benz: Shannon, you brought a couple of funds that you want to delve into a little more deeply. But first let's state the case for allocation type funds--funds that invest in both stocks and bonds. Why do you think the category can be worth a look, even for people who aren't just starting out with their investment portfolios, which is often the type of investor who looks at this type of product?

Zimmerman: Some of the funds are quite unusual and sophisticated investors would want to give them a look as well. Lazy investors will want to give these funds a look, too, or at least the category. It's not necessary to use them in this way, of course, and probably for most people who have them in their portfolio, it's one of many funds. But for folks who are looking for a one-stop shopping solution for both equity exposure and fixed-income exposure, it offers that in terms of the asset allocation.

Beyond that, though, you have to look carefully at what the portfolios hold, not just now in the currently disclosed portfolio, but what they've held historically. The two funds that we are going to talk about are quite different in what their orientation has been toward the fixed-income side of the allocation.

Benz: Let's dig into this "easy-to-own" issue as well. We've got these investor return statistics that marry a fund's total return with the cash flows in and out of the fund. What do we see when we look at that data in terms of how target-date fund investors have done, as well as how investors in more traditional balanced funds have done.

Zimmerman: If you take a step back and you look at the fund universe broadly, investors have not done a very good job of using volatile equity funds very well at all. Typically, you see a big gap for the most volatile funds between what the fund has actually delivered and what investors have gained.

Benz: So what happens is that investors chase that performance, and they get there late.

Zimmerman: Right.

Benz: In time to see maybe performance fall off.

Zimmerman: A fund I have mentioned before, Fidelity Leveraged Company Stock, which I cover, and over the last decade I think the annualized total return is about 11%, and the typical investor less than 4%, which is heartbreaking because the fund has done well, but the investor hasn't done nearly as well.

So, why does it happen? It has to do with volatility. People are reading their quarterly performance reports, and they get the willies whenever their fund is not on the rise. That's modulated with the asset allocation funds. Because it has the equity sleeve and it has the fixed-income sleeve.

So, even though correlations have gotten tighter in recent years, that still does help to give a muted volatility profile. Consistent with the research that's found that investors don't use volatile funds very well, they do tend to use funds with a smoother risk profile much better, and that's certainly the case with … the majority of allocation funds relative to just straight-up equity funds.

Benz: The first fund you want to talk about is from a shop that you cover, it's Oakmark Equity & Income. I associate Oakmark with being a topnotch equity manager, bonds not so much. But you still think it's a good pick.

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Zimmerman: It is a good pick, and you are exactly right. The fund itself reflects that. Historically the fixed-income sleeve of the fund has been concentrated almost exclusively in TIPS and Treasuries--although there are some corporates in there as well. The shop is primarily focused on equities. So much so that the director of fixed-income at Harris Associates, which is the parent firm of Oakmark, is a co-manager on this fund, but he's as much an equity analyst as he is a fixed-income analyst.

The fund remains concentrated in the kinds of securities that it has over the life of the fund. Right now it has about 20% of assets in cash and cash equivalents as well, and they have drifted higher than they have historically on the equity side. About 70% of assets are invested in equities, and so that's caused us to move the fund from moderate allocation to aggressive allocation to reflect the level of equity exposure they have.

Benz: Just to play devil's advocate, Shannon, what would you think about someone just buying a pure equity fund from Oakmark, and then maybe going with a best of breed bond manager, a PIMCO or Met West or whatever that might be?

Zimmerman: Not a bad idea. If you really want to have traditional fixed-income exposure, you're not going to get in Equity & Income. They have expertise in fixed income, but not on par with PIMCO obviously. So, you might want to pair a fund like this that really does use the fixed-income sleeve, as I say, as a cash holding pin, with a shop like PIMCO, that specializes in fixed income and can really give you some diversification within that asset class as well.

Benz: It has moved to a new peer group, Shannon, to this aggressive allocation peer group. How does its performance stack up relative to those new, more equity heavy peers?

Zimmerman: It's still looking good, because it is also equity heavy. Oakmark, of course, has a very long track record of successful stock selection with a value approach that is sort of non-traditional. A lot of times, a traditional value fund might focus on certain sectors with low price multiples. That's not the way they work it at Oakmark.

Any stock can be a value stock provided in their estimate there is a big enough gap between the stock price and what they think it's worth. Three of the seven funds have portfolios now that land in the large-growth square [of the Morningstar style box]. They're still in large-blend categories in most cases, but the proponents of the funds' assets are invested in stocks that we consider growth stocks.

Benz: I know Oakmark has restricted access to the fund at various points in time; you could only buy it through Oakmark. What's the status of the fund's availability right now?

Zimmerman: It's open now to third-parties--you can through Oakmark as well, but you don't have to, which in the past as you say is what they've done to curtail inflows. That's not the case now. In fact, it was the one Oakmark Fund that had in recent years some outflows because there was some underperformance in relative terms. It was still doing well in absolute terms, but not so much relative to its category peers. So, there were some outflows. They were modest, but they took away their restriction, so you can invest in it across the platforms.

Benz: Let's take another fund, Dodge & Cox Balanced. This is kind of the classic balanced fund. It also has a value style on equity side, and a terrific fixed-income manager in this shop's case.

Zimmerman: That's right. So, what you don't get with the Oakmark fund is that traditional bond fixed-income expertise, that can provide diversification across sectors, across credits, and you have some insight on duration. They're not really doing anything fancy, so to speak, at Oakmark, but Dodge & Cox Balanced, they're quite sophisticated in what they've been able to do with the bond sleeve. Right now they have a pretty low duration, so they're not taking a lot of interest rate risk, and the equity portion of the fund is, as with the Oakmark Fund, quite high in terms of the exposure that the fund has to stocks right now.

By prospectus, that fund can go as high as 75%, and it got close to that level over the last couple of years and did quite well, as you would imagine it would. It's in the moderate allocation category for us, but higher than the category norm, and in the period when the market is rising, that served it quite well. But so, too, did stock selection serve it well, and then sticking to their guns with some picks that had caused quite a bit of a pain in terms of underperformance over the preceding period, HP is a good example.

They took a lot of flak from some investors and from some pundits for sticking with that stock through a period of time that really dragged on returns for the fund. Well, they stuck with it, and last year HP was up more than 100%. You think about that kind of a sharp rise and you think about Dodge & Cox being a value shop, which it is, but like Oakmark, just because a stock has appreciated 100%, or even the multiples start to look a little bit rich, if the share price still implies a discount to what the management team or the investment committee thinks it's worth, they'll stick with it.

Benz: More broadly, Shannon, can we read into these value managers having equity ratings that are pretty high relative to their allowable ranges? Is it that they're just not that attracted to fixed income at this point and finding more values in the equity market, even though stocks aren't especially cheap?

Zimmerman: Yes, and that last point is huge. Yes, on the Oakmark side. I imagine so on the Dodge & Cox side, but that's clearly the case with Oakmark. Oakmark has 20% in cash and cash equivalents. So, that's a statement--it has to be--on what they think of the prospects for the type of securities that they have typically had in the fixed-income sleeve of that portfolio. Not all that promising. And so, it's no surprise to me that, given the characteristics of the bond market now, they have seen the equity exposure tick up.

But your last point is important, and I talk with all my managers about this now. The market … what are we in, the fifth year now, of a nice rally coming out of 2013, which was obviously a terrific year for equities. Well the market looked fairly valued to a lot of people at the beginning of last year. Well certainly by the end, maybe it's even overvalued. Where do you go? Where are the opportunities? Consistently, and maybe predictability, the answer is, you can always find individual opportunities in any kind of market environment, and that's what we're paid to do.

Benz: Shannon, thank you so much for being here to discuss all-in-one funds.

Zimmerman: Absolutely.

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