Kinnel: Avoid These 3 Widely Held Funds

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Not all large funds deserve investors' dollars. Joining me to discuss some sizable mutual funds that have negative ratings is Russ Kinnel. He is director of manager research for Morningstar.

Russ, thank you so much for being here.

Russ Kinnel: Happy to be here.

Benz: Russ, let's quickly run through the ratings process, what you and the team look for when you are giving the mutual funds ratings all the way from Gold to Negative. What are the key points that you look for when assessing funds?

Kinnel: Well, if you think about it, it's really, we're looking for competitive advantages, and we're looking for them in five fundamental areas: People, Process, Parent, Performance, and Price.

Benz: OK. So, you brought with you today some very large funds that have negative ratings, and let's take them one-by-one. Inevitably, they fall down on a few of these areas, and that's what causes them to receive negative ratings.

Let's start with Ivy Asset Strategy. It sounds like there are a few concerns, some turnover at the firm, substantial outflows, as well as some odd issues related to a private placement. So, let's kind of talk about how the mosaic of the fund ends up with this negative rating.

Kinnel: That's right. Really, there are some important competitive disadvantages which is what gets you to a negative rating. So, this is fund, when I think about it in the big picture, it's one that hasn't shown the sort of controls I would like. It got incredibly popular, had some really good performance and didn't close the fund early, and the fund got very, big and I think that's the first of its problems--that as it got large, it didn't really adapt the strategy to that very large asset base, well over $30 billion. So that was the first problem, was that they didn't adapt nor did they close the fund. That would have been a more responsible way. And so, that led to a lot of problems, had performance really declining sharply, as well as some key managers leaving.

And then if you fast-forward to today, performance has been terrible, outflows massive, nearly $20 billion in outflows the last two years which is extraordinary. And now, that's causing problems because again we see some control issues. They've got a very big stake in private placements. And what's happened is that money has come out of the fund. They've actually sold the liquid holdings, allowing the private placements to balloon to where most recently they are 17% of the fund, 15% in one particular private placement which is really extraordinary level of risk, not something I think many people expect from an allocation fund. So, you can see here, sometimes outflows don't really have much of an effect on a fund. Sometimes they have a big effect. And I think the fund is really showing a lack of risk controls to get in this position.

Benz: Before we leave this fund, can you just quickly talk about private placements generally, what that means, and how common are they among the mutual funds that the team tracks?

Kinnel: Yeah. So, private placements are stocks that are not quite yet ready to go public. So, they don't trade on an exchange. And so, usually investors, whether they are mutual fund or something else, are committing to a certain amount of time and there may or may not be a way for them to get out of that position. In this particular case, they say they've got a way to get out of that big position sometime in the first half of this year. We'll see if that actually happens. But in any case, that's much less liquid.

We do see other funds that have held private placements, even T. Rowe and Fidelity. But generally, they are keeping them to pretty small positions. You don't want them really to get very large for the reasons we're seeing,that they may start out at one level and either through appreciation or outflows end up at a much bigger level. So, that can be really a big problem. So, keep it to a small amount. More typically, if you look at what a T. Rowe or Fidelity fund might have in a private placement, it might be 50 basis points or something like that. But in this case, you see a much larger and in a fund, we really wouldn't expect it in.

Benz: Right. A follow-up question too, Russ, on the asset size issue. This is a world allocation fund, so truly like a go-anywhere fund. When I think about the categories that seem most able to handle a lot of size, I would think that this would be a good category. But it sounds like due to some of the specific issues going on at this fund and the types of securities they've held, it just has not been a good place to get very large and then too see assets outflows later on.

Kinnel: That's right. It's pretty rare that you worry about asset growth in a world allocation fund. But sometimes they may have concentrated portfolios. In this case, you have private placements. Earlier they had a problem with S&P mini futures contracts which the manager used to make adjustments, make some quick market calls and it's not that liquid an investment, and in fact, some people think that the managers' big move a few years ago to sell S&P mini futures actually was related to the flash crash. That's still in dispute, but I think it illustrates that they didn't really adapt their strategy. No one said, well, we need to find something more liquid to do this, or we need to tone down these kind of macro bets because we're now too big a piece of the market.

Benz: Right. The next fund that we're going to cover is Ivy High Income. One thing that jumps out at me when I look at this one is it's got a really big yield. So, for people who are attracted to income, it might pop up on their radar screens. But let's talk about why you and the team think that investors should temper their enthusiasm for this one.

Kinnel: Yeah. Well, as often happens, outsize yield means outsize risk. This is fund that's got about 44% in CCCs or lower compared with about 13% for the benchmark. So, that's massively higher number in the lowest quality.

Benz: So, this is even relative to a junk bond benchmark, it's loading up on the junkiest bonds.

Kinnel: That's right. It's the junkiest of junk, and of course, what that means is, you're going to get a good yield and if the economy keeps chugging along, you'll do really well. You can kind of see that in returns that in 2016 it actually did well because we had some economic recovery, rebound and some of the energy names helped. But in years like 2015 it hurt and of course, in years like '08 you can really get crushed with this kind of risk. So, our bond team really looks for very good experienced, skilled managers backed by a really strong group of analysts. But this is a fund that's had manager turnover, and it's got some relatively inexperienced analysts, a relatively small analyst staff supporting it. So, really, a bad match of strategy and people.

Benz: So, the strategy of gravitating toward very high-risk bonds combined with maybe a less tenured management team and just overall fewer resources than some other comparable funds.

Kinnel: Right. We don't think it's a risk that makes sense for most investors to take.

Benz: The last fund, it's actually a series of funds, this is State Farm LifePath funds. These are target-date products. Let's talk about the knock on this whole series. It really comes down to expenses.

Kinnel: That's right. I can really explain the problem here in a short question. Would you pay 1% for an index fund?

Benz: No.

Kinnel: I wouldn't either, and that's the problem here. Essentially this is a fund that--it used to have a mix of active and passive and it was even higher cost. Now, it's just passive, but it's charging 1%. You think about a comparable Vanguard fund is charging 15 basis points. That's a huge difference. And when you think about how this is a fund meant to be a big chunk of your retirement portfolio, that's really not an acceptable risk. It just doesn't make sense.

Benz: OK. Russ, thank you so much for being here to provide a recap of these negatively rated large funds. It sounds like based on everything you've said that these are ones to avoid.

Kinnel: For sure.

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