Add Diversification With These 3 Small-Value Funds

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Small value has had a big turnaround so far in 2016. I'm here with Russ Kinnel, he is our director of manager research, to look at some of his favorite small-value funds.

Russ, thanks for joining me.

Russ Kinnel: Good to be here.

Glaser: So, let's talk a little bit about this turnaround in performance for small value. It went from kind of the bottom of the pile to the top. While on the other hand, large growth went from the top to the bottom. Is this kind of normal cyclical behavior, or is there something more profound going on?

Kinnel: I think it's normal cyclical behavior. You always have the markets and the economy have rotation naturally. So, last year energy, natural resources, some of the stuff you see a lot of in small value were getting crushed. Now they've been rallying. Conversely, healthcare and tech names had a tremendous run for a number of years ending last year. So large growth was great last year. This year they have come down to reality. And of course, there is also a pricing element too. As those areas do really well or really poorly, we tend to overreact and so growth in tech and healthcare did really well and that meant they were kind of pricey and therefore, vulnerable to a little bad news. On the other hand, you had these natural resource areas that so many bad things were already priced in, just a little bit good news would help. So it's sort of a natural cycle to see, and it's just particularly pronounced this year.

Glaser: So, this is an argument to stay pretty broadly diversified?

Kinnel: Yeah, I think stay broadly diversified. Don't give up on a sector. If you've got all of your investments and say, it's year-end and you're just saying, OK, I'm going to sell the thing that did worst and put it into the thing that did best, you maybe inadvertently buying high and selling low.

Glaser: But after this runup in small value so far in 2016, is it still time to maybe look at a small-value fund? Are there still some managers there who you think could be worth taking a closer look at?

Kinnel: Sure. I think you definitely have already missed some of that run. But if you're really looking out long term and you're planning for 10 or 20 years, it's probably always a good time because I don't think you want to worry too much. I wouldn't jump in with the idea that the next 12 months it's going to keep outperforming. I have no idea if that's going to happen. But I think you always want to build to that long-term plan and if you've neglected small value at this point, I think this year is a good illustration of why small value, for some of its quirks, has some good diversification value for a portfolio.

Glaser: Let's look at some of those strategies that you like. What's the first one?

Kinnel: Right. Well, I actually chose to highlight some funds that have been doing particularly well this year, but we also have medalist ratings on them so they are good bets long term. So, Royce Special Equity is one that's up over 12% this year. It's a fund run by Charlie Dreifus, who is kind of an accounting geek, who just really likes clean balance sheets and sort of typical stuff that's driving it, just boring retailers and industrial names and you really just--it's never very exciting names in the portfolio, but that's kind of the beauty of it, is that you have good balance sheets and low valuations and you get years like this out of a fund like that.

Glaser: What's the second one?

Kinnel: Vanguard Small Cap Value is doing really well this year. It's Silver-rated, and it's up 11% this year. Interestingly, the small-value category does not quite match its sector weightings. The index fund's financials weighting is significantly less than the peer group and so that's been helping its performance this year but of course that's not why you buy it for the long term; you buy it because it's very cheap and those low costs work year in and year out. So that's why you'd own it for the long term even though there's some quirks that are helping it this year.

Glaser: What's the final fund that's done well?

Kinnel: Perkins Small Cap Value; it's a little like Royce in that it really likes cheap, boring names. They have got a packaging name that's doing well, a filter-maker, a pump-maker; incredibly boring stuff but it tends to be cheap, tends to be cyclical and so this is a sort of fund that will have a two- or three-year run that they really do well then they may give a little bit back, but it's still a really well-run fund and we rate it Silver.

Glaser: Well, Russ, as always, I appreciate your insight. Thanks for joining us.

Kinnel: You're welcome.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.