How Morningstar's Top-Rated Core Stock Funds Have Performed

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Large-cap blend mutual funds form the core of many investors' portfolios. Joining me to discuss the performance of Morningstar's top-rated funds in this category is Russ Kinnel. He is director of manager research with Morningstar.

Russ, thank you so much for being here.

Russ Kinnel: Happy to be here.

Benz: Russ, you periodically take a look back at performance of the various funds that we have rated as medalists. You recently took a look at the large-cap blend group, and you looked at the Gold-rated funds, the top-rated funds in that group and evaluated their performance. And I know that has some role in your evaluation; it doesn't completely influence the evaluation. But let's start with some of the funds that you evaluated. Vanguard Total Stock Market, that's kind of the core fund for many investors. It's the baseline holding for a lot of investors. Its performance has really been quite strong recently, right?

Kinnel: That's right. It's a top quartile in just about any of the trailing periods. So, very strong performance, very consistent. If you look at the rolling three-year periods over the last 10 years, it's outperformed in every single one of those, which of course, is a great result for investors because it means you've got a pretty smooth dependable ride. So, it's really been a consistent performer for people.

Benz: One question I have is--and I think we both agree that indexing is a terrific long-term strategy, especially with the cheap core product like this--but do you think that investors should be aware that there will be times where the fund's trailing returns don't look quite as good as they have recently?

Kinnel: Definitely. Low costs and tremendous diversification make things pretty predictable and dependable. But when you have a cap-weighted index, there's going to be times when smaller caps lead and those cap-weighted indexes will look much more pedestrian. We saw it starting in 2000 when you had a big market cap reversal, and it's certainly possible we could have that again if small caps have a long stretch of outperformance. So, yes, I would say that the next five years probably won't be quite as smooth as the last five.

Benz: The next one I want to talk about is Vanguard Dividend Growth. It's closed to new investors. And its performance had been quite strong, but more recently it's ebbed away a little bit. Let's talk about what's been going on there.

Kinnel: That's right. We really like this fund because dividend growth kind of puts it into these high-quality names where you've got low debt and good growth prospects. It makes it a nice defensive fund. But occasionally, it's going to get left out in a rally. Postelection, we saw financials and energy really rally strongly. That's not where this fund is and therefore, it's not that it lost money but it significantly lagged. And you see that even in the five-year returns. Ending 2016, it actually was behind for the whole five-year period because it really missed out on that two-month rally.

Benz: So, when you and the team are looking at a fund like this, you put up with the short-term underperformance because you think it's consistent with the fund's strategy, it's sort of how you would expect it to behave?

Kinnel: That's right. It's a defensive fund with good quality names, and this wasn't a quality rally, so that's OK. It will probably rebound nicely. We would worry more if this was a quality rally, if other dividend growth strategies did much better, then we'd worry. But really, it's just, sort, of the strategy being a little out of favor. Usually, the funds come back pretty well from those kinds of bouts.

Benz: OK. You probably also worry if it underperformed in a market sell-off. This is a type of fund that we would expect to maybe hold its ground a little better than, say, its peers or the broad market?

Kinnel: That's right. The fund did wonderfully in the '08-'09 bear market. So, yeah, I think, I would worry more if it lost that defensive posture.

Benz: OK. Let's take a look at another fund that in some ways exhibits the opposite performance pattern where it has come out swinging. In this postelection rally, it's performed very, very well, and so its long-term trailing returns are really good, too. That's Oakmark Select. Let's kind of talk about the thesis for that fund, why you and the team like it, and what's been going on with performance recently.

Kinnel: Yeah. I think what's happened recently really illustrates the strength Bill Nygren's approach and that is, he is a value investor and he is not shy of controversy. Occasionally, that means people will think he has lost it. (In) '08 he had Washington Mutual …

Benz: And a big position?

Kinnel: A very big position, top holding in the fund--people thought he was crazy. More recently, the fund has held Chesapeake Energy and AIG, too, very controversial names, companies that really did terribly and had some really big problems. But the last year or so, they have done tremendously well, especially postelection, because people are expecting a little less regulation for banks, financials in general and energy and so Oakmark Select has done particularly well and its trailing return record is just really strong. I think that illustrates both the strengths and weaknesses. You are going to have some dry spells with a fund like this. But clearly, the approach works. Clearly, there's some advantage in being a savvy investor in controversial names.

Benz: Another fund that you took a look at is, Yacktman Fund, AMG Yacktman. Let's talk about that one and how it kind of rides the line between large-cap value and large-cap blend and how that has influenced its performance recently.

Kinnel: That's right. It's really on the border between value and blend. So, it tends to do a little better when value performs well, but also does better in defensive times. So, it loses less in down markets. And so, recently it's been lagging because of that bias. They tend to hold a lot of cash, usually something like 15% to 20%, but also what names they do own tend to be rather steady names. So, again, kind of a fund that's going to be left out of a rally like we've seen. But again, its five-year returns are not very good, but actually has the best 10-year returns of any of our large-blend Gold medalists. So, we still have faith in the fund.

Benz: And this is another fund that performed really well during the financial crisis, the market downturn from 2007 through 2009?

Kinnel: That's right. Focused funds can play defense well. For sure you still have some issue risk. But this is a fund with cash and the kind of names it owns, it tends to do well in downturns, relatively speaking that is.

Benz: Right, right. This is a fund that has had a manager change recently. Let's talk about that because I think sometimes investors see lagging performance and then think, aha, is this because of this change in the manager's office. What's your take on that question?

Kinnel: Yeah. So, Don Yacktman recently stepped down leaving Stephen Yacktman as the lead manager. But really, this was a very long transition. Stephen Yacktman has really been the driver of the fund for quite a long time. So, we don't think there's a link between recent underperformance and Don Yacktman stepping down. I think, really, it's just that the fund is behaving the way you'd expect, and the two are not really linked.

Benz: OK. Russ, thank you so much for being here to summarize the performance of some of our top-rated large-cap blend funds.

Kinnel: You're welcome.

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