Ivy High Income's recent manager turnover and Templeton Developing Markets' long-deteriorating performance have led to downgrades, says Morningstar's Russ Kinnel.
Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Morningstar has placed Negative ratings on two fairly high-profile funds. Joining me to discuss those calls is Russ Kinnel. He is director of manager research for Morningstar.
Russ, thank you so much for being here.
Russ Kinnel: Good to be here.
Benz: Russ, I think one question you probably get a lot is that when you look at the rated funds, there are more funds with positive ratings and Medalist ratings than there are funds with Negative ratings. Why is that?
Kinnel: Well, the reason is we focus on funds that our customers are most interested in. Financial planners, individual investors, institutions--what are they most interested in? Generally, they are interested in funds that have positive characteristics: good managers, low cost, high asset bases. All of these things mean that we're kind of looking at the best part of the fund industry.
A lot of the potential Negative funds are funds that are very small with very high expenses that no one is even bothering to look at. [These are funds that our analysts] just naturally screen out, whether they are screening on fees, manager tenure, or performance. If we covered the whole universe, yes, we would have probably a quarter or so of the funds in Negative territory. But is it worth our time to spend as much time on PIMCO Total Return (PTTAX) as a $3 million fund with a 3% expense ratio? No. There is a reason that it's skewed, but it's only because we are selecting a smaller subset--about one sixth--of the whole fund universe to cover.
Benz: So, when I see a Negative rating on a fund, how should I read that? Does that mean that I should sell it right away?
Kinnel: Well, we think there are negative consequences. We think that the outlook is not very good. So, it's probably worth at least thinking about whether you want to do that. We made a conscious effort to avoid saying buy-sell-hold. Instead, we have Gold-Neutral-Negative.
There's a reason for that, which is that we don't know what's suitable for an investor; we don't know of your tax situation; we don't know all the details; we don't know, say, if you're investing in a 401(k) and maybe you've got to pick the least bad fund. So, we avoid saying that. But certainly, I think if I had a Negative-rated fund, I would think long and hard about whether I want to hold on to it.
Benz: The analysts have given two funds Negative ratings--recently in one case and a little less recently in the other. Let's start with the first one. It's a very large fund, Ivy High Income (WHIAX), which operates in the high-yield bond space. Let's talk about what we think are knocks against this fund and that we think could impede performance going forward.
Kinnel: If you look at the surface level, the fund looks pretty good--a pretty good performance.
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Benz: Nice yield. I looked at that.
Kinnel: Nice yield, which, of course, investors love a good yield. But we're now on the third manager in less than 12 months. Most recently, the previous manager was dismissed for non-investment-related reasons--we don't know what. But the bigger issue is that you're on to a new manager without as much experience as prior managers, and you have a fairly thin staff in a fund that has grown very rapidly.
Staff levels are huge for high-yield and bank-loan funds because they tend to invest in very low credit quality companies which require tremendous amounts of research. If you think about being handed a stack of papers on a company that's got a high level of debt and trying to figure out whether they are going to be around long enough to pay off all of that debt, and if not, what's going to happen to that bond? That takes a lot of research and a lot of experience to do a good job. So, staffing levels are really important, and this fund has a fairly small staff relative to some of the other high-yield funds.
Benz: I noticed in the analyst report that there was mention of this fund actually having a pretty high stake in bank loans relative to other high-yield bond funds.
Kinnel: And bank loans are nice in that they give you some protection against rising rates, but high-yield debt is relatively illiquid and bank-loan debt is even more illiquid. So, again, that's a problem you worry about at a fund like this. And in fact, in July, it actually just flipped into negative outflows--about $890 million. On a fund over $10 billion they can manage that. But if, say, those redemptions accelerate at some point, that could be a real problem with owning less liquid securities like that.
Benz: We also have a Negative rating on the parent company here. Is it the manager turnover issues or anything else?
Kinnel: There are a number of issues at the firm, but I think you're right. The parent is another important piece of a Negative rating. You often say, "Well, maybe they don't have the depth." And in a case like this, I think there is also the fact that they really have had all of their growth through two strategies. And so, you think they're probably less inclined to close those funds to new investors and maybe then let them get a little too large.
Benz: Another fund that people may be somewhat surprised to see has a Negative rating currently is Templeton Developing Markets (TEDMX). This had been, at least 15 years ago or even more, a very high profile fund. Now, it's down to about $2 billion currently, and we are rating it Negative. What are the key reasons for that?
Kinnel: Templeton Developing Markets was once synonymous with emerging markets. And Mark Mobius, its manager, was really the person out there evangelizing about emerging markets. But unfortunately, performance has just eroded for a very long time. And performance isn't the only thing we look at; but when you have a manager with a record going back to 1991--and it's a bad record--you have to say, "Well, we now have a very large amount of evidence and it's not very good."
So, that's a big driver. If you go back to '91, the fund has lagged its peers and its index, and it has continued to do so. So, it's not like things have improved. And at the same time, even when it was very popular and very large, it had a very high expense ratio. Now, it has actually cut the expense ratio a little, so that it's average but still kind of high at over a 170 basis points.
Benz: So, if you were looking for a fund in the high-yield bond category or in the emerging-markets category, we think there are better options.
Kinnel: Most definitely.
Benz: Okay, Russ, thank you so much for being here.
Kinnel: You're welcome.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.
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