2016's Comeback Kids

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. The market has enjoyed a sharp recovery over the past month. Joining me to discuss some funds that have mounted a comeback is Russ Kinnel. He is director of manager research at Morningstar.

Russ, thank you so much for being here.

Russ Kinnel: Good to be here.

Benz: Russ, let's start out by talking about the market environment that prevailed in January. People, I'm sure, remember, it was a really stressful time for a lot of investors. So, let's talk about the types of investments that did well during the early innings of this year as well as those that performed especially poorly.

Kinnel: Yeah, we started off really with a lot of the higher-quality, more defensive stocks and the funds that like them holding up best, and many of the funds that had done best in the prior year were off hard because healthcare, tech, and some of the other areas that had done so well were among those that were hardest-hit early on in this year.

Benz: And then since that time as the market has recovered we've seen sort of a reversal of all of those themes, right? It's been sort of a risk-on type environment?

Kinnel: That's right. Commodities, especially gold, are really rallying; emerging markets are rallying and of course, there are a few links between those groups. So, now, you look at it today and many of the hardest-hit groups from last year are the best this year.

Benz: So, you brought a list of funds that were not necessarily performing so well prior to the recent past, but so far this year they have staged a really terrific recovery. Let's start with Vanguard Precious Metals. This is at the top of the list with just a stratospheric return so far in 2016, lousy 2015.

Kinnel: That's right. Gold and some of the other mining and material stocks have had tremendous rallies this year after many years of decline, and so the fund has really taken off. It's kind of interesting that within the precious metals category this is actually a more diverse fund and Vanguard has tried to spread it out. So, it's not just a gold fund, yet it's still extremely volatile and even though it's doing well now of course, it's one of those funds you need to be careful with and not make a big part of your portfolio because it seems like it's always at one extreme or another. I suppose there are some times when it's been more middling but those kind of funds are just pretty hot to handle.

Benz: Yeah, I guess the risk with any fund like that is that if you were trying to hang on to it, it might have tested your patience too much and you just didn't hang on in time to enjoy the recovery?

Kinnel: That's right. For me, the solution for a lot of those volatile funds is just position sizing; if a fund is 3% of my portfolio, it's not going to bother me too much if it's down 30% one year. And I think that's really the answer: Don't let these be your core; keep these kind of funds as a small position. That may be a nice diversifier, but you don't want to let the tail wag the dog.

Benz: A lot of different hard assets categories have recovered and the energy sector has been particularly strong. Let's discuss a couple of names there. T. Rowe Price New Era, which is sort of a diversified natural resources fund, as well as Vanguard Energy, they have also enjoyed a really steep recovery so far this year.

Kinnel: That's right. These funds are actually on the tamer side of energy because they tend to own the big integrated companies, but in reality they are still pretty volatile and energy is coming back. So, again, it just illustrates one of the challenges of being an investor is just when you are about to give up on something or maybe just after you have, that's when the rally comes. I think it's also a story about valuation that oil got so cheap even though there were still lots of negative fundamentals eventually it had to start coming back, and the same is [true] for those companies, that they got so cheap that at one point it didn't really take much to get a rally going because people could see, well, I don't really need a lot of things to go well for this company to pay off for me. So, it's a good story about valuations and really just contrarian investing in general I think.

Benz: One fund that may be a little surprising that pops up on this list, it's got a roughly 12% gain for the year to date here through late March, is Franklin Utilities, and I guess that's the type of category, the type of fund that I would have thought might have performed really well when people were feeling defensive. Why has it performed so well recently?

Kinnel: Yeah. A big part of that story is just interest-rate sensitivity. This is a fund that compared to its peers focuses particularly strongly on U.S.-regulated electric utilities and natural gas utilities. So, therefore, that tends to lead you into higher-yielding, higher-yielding makes it a little more interest-rate sensitive. So, there is some correlation with long bonds and so when they rally, a fund like this tends to rally, and vice versa.

Benz: So, people breathing a sigh of relief that the Fed isn't going to be really aggressive in terms of raising rates, is that why a sort of pure-play utilities fund would perform well?

Kinnel: Yeah, that's right. So, it's also worth thinking about the people who like utilities funds tend to be the same people who like fixed income because they both throw off yield, but unfortunately it also illustrates that there are limits on how good a diversifier it is.

Benz: One fund that was toward the top of your list of funds that have the best performance so far in 2016 is not narrowly focused like some of these other ones we've talked about; it's Artisan Value. Let's talk about how a diversified fund could have strong enough returns to lift it to the top of your list of funds in the Morningstar FundInvestor 500.

Kinnel: Yeah. When you think about the last few years, you have generally the markets doing really well, most things are going up, but basic materials, energy has been losing money significantly. So the funds like Artisan Value or any that kind of have maintained a bias towards those areas even a modest stake in those areas has led them in the past to really underperform in recent years and now this year we're seeing the flipside as they are really outperforming because as the sell-off gained steam, more and more fund managers gave up on basic materials and energy, but now we're seeing the benefits. The Value team at Artisan is one that we've long liked but has really had a rough go of it with the prior three years' performance was really bad, but now we're starting to see some benefits to that strategy and again, a very contrarian kind of performance story here.

Benz: So, a Bronze-rated fund currently. The fund I want to conclude with is even more diversified still. This is PIMCO All Asset All Authority. It wasn't right up there among the very top gainers on your list but still has had a great recovery so far in 2016. Let's talk about some of the themes that have underpinned its comeback.

Kinnel: That's right. Again, you have an allocation fund that relative to its peer groups has a very big bias towards emerging-markets stocks and bonds. So, up until recently that's really hurt it. So, if you go back a few years before that the fund has had brilliant performance, then a significant slump and now things are coming back. As a contrarian I think one of the things I want to look for are funds that are still well-run but are in a slump because you can sometimes catch a rebound like this. But of course, it's very difficult to assess that, but this is a fund that has emerging-markets exposure. It has some non-dollar exposure, which also has helped it.

Benz: So, you've kind of given lessons along the way for each of these funds. More broadly, when investors see maybe a sharp reversal in their portfolios where they have holdings that once were performing poorly are performing well and vice versa, what are some general takeaways? How should investors operate when they experience a big market change in sentiment like the one we've had so far in 2016?

Kinnel: Well, I guess, part of it is, it's an exercise of diversification that if you see all of your funds performing well or all of them poorly at the same time, then it's a good time to do something like use the [Morningstar Portfolio Manager] Portfolio X-Ray feature to see do I have some big biases there, do I have, say, a lot of natural resources or nothing or something like that that might explain it, and maybe I want to make some adjustments to make sure I'm diversified. And then I think a more general point would be simply that you don't want to chase short-term performance because if, say, I had bought the best performers from 2015, I would have been loaded up with healthcare and tech and I would have gotten hurt. So, that's another point is just short-term performance often is pointing you in the wrong direction.

Benz: Russ, thank you so much for being here to share your insights.

Kinnel: You're welcome.

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