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2 New Medalist Funds

2 New Medalist Funds

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Morningstar analysts are constantly reviewing funds and bringing new funds under coverage. Joining me to discuss that ratings process and to share two newly rated funds is Russ Kinnel. He is director of manager research for Morningstar.

Russ, thank you so much for being here.

Russ Kinnel: Glad to be here.

Benz: Russ, let's get into coverage and how you and the team decide which funds to bring under coverage.

Kinnel: In general, we are looking for funds that are promising to add. Maybe they have got good managers, they are from a firm we know well, some good fundamental reasons. Obviously, we won't know for sure how good it is until we have done the full research, but we are looking at those kinds of factors. Of course, we are looking at things like assets under management as well as client requests. If lots of people are asking us to cover a fund, obviously that's going to be a factor, too. There's no set formula, but those are among the things we are looking at.

Benz: In terms of the ratings process, where you assign funds medalist ratings or assign them as Neutral or Negative-rated funds, let's walk through that--some of the key factors that you and the team take into account.

Kinnel: The ratings process is really about focusing on the fundamentals. That starts with the managers and their strategy, understanding how good are the managers, what kind of analyst support do they have, how does that system work. In other words, how do the managers work together, how do the managers and analysts work. Then thinking about the process, is it a sound process, are they disciplined. When you look at those two together, is there a competitive advantage that comes from that, is that combination of managers and process doing something different or better than the competition. Of course, then we go on to look at price, fees are very important. The parent company--if you are investing for the long haul, the parent really will have a big impact on the quality of your investment. Then we look at performance as well. We don't give it a big weighting, but we do care how the fund has performed in the past.

Benz: One question I had, and it seems particularly pertinent right now, we are almost 10 years into the current bull run in the market. How do you ensure that the analyst recommendations aren't unduly swayed by how they have performed over the past decade. How do you make sure that we are not king of performance chasing with the ratings?

Kinnel: That's a great question. It's always a temptation to weigh too much on the last three years or five years and say, well, these managers, they seem to really know it. Conversely, if their style is out of favor, you can blame them too much. For sure, we try to correct that. One is looking at the long-term. Ideally, if you've got a fund manager with, say, a 15-year track record, you can look at that and weigh that a lot more heavily than recent performance, but also look at the fundamentals, because we know performance is very fleeting, things go in and out style, but also understand what should we expect from this strategy. Say, it's a deep-value strategy, OK, maybe I can give them more slack today in a long-running bull market. On the other hand, if I'm looking at a momentum strategy, I would expect it to have hit the lights out. You kind of adjust for those things as well.

Benz: You brought a couple of funds that have new ratings. Speaking of deep value, LSV Small Cap Value is one, it's what our analysts characterize as a deep-value small-cap value strategy. Let's talk about that one.

Kinnel: This ticks a couple of boxes of what we look for in a new fund, new to coverage that is. One is, we've covered LSV's larger cap value funds, and we liked what we saw there, and we knew the process was very similar on small cap. In addition, because small-cap funds are often closing, there is a real demand for open small-cap strategies. And so, we really focus on that. In the case of LSV, you have a really academic Ph.D.-driven process. It's a quantitative process of looking for very good cheap companies that have prospects to outperform. As you mentioned, they are deep value and that means, of course, the last few years can be kind of hard on that deep-value strategy. Deep value tends to do best early on in the economic cycle because they do worse in a recession generally and then come out really strong as the demand really flips. You have to take that into account. But we like the managers, we like the strategy, we like the discipline. You don't see that kind of a discipline everyday in value. All those are good things and we actually rated it Silver right out of the box which is uncommon, too.

Benz: A follow-up question is, anytime you see a quantitative actively managed fund, it seems like maybe a good comparison for such a fund is an exchange-traded fund that is sort of using similar factors to influence its portfolio. How should investors think about that issue? How much is fair to pay for an active quant fund when there are these very cheap factor funds available?

Kinnel: Strategic beta as well as more traditional indexing has certainly raised the bar on active, because now you can say, I can get that basic exposure no matter just about what it is, for cheaper than the active fund. I think you are right. You do want to understand that, and I think in a case like this maybe some of its best competition would from DFA's value funds which kind of themselves are on the borderline between active and passive, and they have academics who are also looking for factors that will outperform. I think if you look at the records and you look at the process, you see they are a little different and they both stand out well. We've got medalist ratings on both.

Benz: Let's look at another fund. This is Harbor Strategic Growth. This is a mid-cap blend fund, a pretty small fund. It has a Bronze rating. Let's talk about the factors that went into that rating and why it doesn't rate an even higher rating.

Kinnel: Harbor is a firm that's pretty at finding good subadvisors. People are probably familiar with funds like the Harbor Bond run by PIMCO, etc. When they find a good manager, we're interested. This is a fund that they adopted about a year ago, run by a small firm called Mar Vista where they have a good track record in this strategy going back even beyond the fund itself. It's really a pretty impressive group. Their strategy is kind of looking for firms with competitive advantages but whose shares are trading at a significant discount. What that means is, you are not going to get the really aggressive names that have done so well lately. The three-year and five-year returns are very pedestrian. It's not surprising that the fund hasn't drawn a lot money, but it's longer-term performance is good, and we think it's an interesting team. We see a lot of value there even though the recent performance is nothing impressive.

Benz: Russ, thank you so much for being here to talk about these two funds and to shed some light on the ratings process.

Kinnel: You're welcome.

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

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