US Videos

Kinnel: A Beating for China, Energy Funds in 2018

Russel Kinnel
Christine Benz

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. The year 2018 ended on a sour note, and most mutual fund categories ended the year in the red. Joining me to provide a recap of the past year's worth of mutual fund performance 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, it was a disappointing year, and it really didn't matter whether you were a bond investor or a stock investor. Can you discuss some of the forces driving down both stock and bond markets last year?

Kinnel: You are right. There was really a red ink across the board, though bond losses much less so than equities. But I think you had a number of factors going in. You had things like trade tensions, growing deficit for the U.S. but also, really just underscoring all that I think is that we have had a tremendous bull market. Equity valuations were stretched and so probably more vulnerable than usual for a correction. You can only go so long before you have a correction. I think all of that was in play. And of course, it's easy with hindsight, but even now I don't think we know exactly why the market sold off the way it did.

Benz: Right. And it's not necessarily done either. In the beginning days here of 2019 we are also seeing some volatility.

Kinnel: That's right. I think that's the real concern is, when you consider how much the market has gone up in the last eight years, if all we have is that 20% haircut, it's really not a big deal. But the real concern is, that obviously could just be the first leg. We tend to overdo it both on the upside and the downside. There's no reason we couldn't have a real bear market this year.

Benz: Really good point. Let's take a look at some of the hardest hit categories as you survey the fund universe, some pockets of real weakness. Energy sector, China was hard hit. What were some of the other areas?

Kinnel: Also, we had foreign small-cap funds were hit pretty hard, too. In that case, it was really the case of a rising dollar. Most foreign equity funds are not hedged. But also, worries about Brexit and other trade issues hurt them. That's also part of what hurt China. China was hurt by trade tensions with the U.S., declining property prices in China, and just some general worries about growth. Energy, of course, pretty straightforward: Oil declines, energy stocks go down.

Benz: Let's talk about what we saw on the domestic equity side. You noted that there was a huge bifurcation between large-growth stocks and small-cap value stocks. That's interesting because really the large-growth stocks or certainly the technology stocks have been kind of at the epicenter of the recent volatility. But the long-run pattern is that large-growth stocks have performed very, very well and indeed did in 2018.

Kinnel: That's right. I've been watching large-growth versus small-value and it's a very long run that large-growth has outperformed small-value to the point where now if you look at the five-year returns, large-growth returns are about 3 or 4 times greater than small-value. And interestingly, as you say, even on the downside, large-growth lost a lot less than small-value. Part of that was because we had a tremendous FAANGs rally to start the year and then a lot of those big tech stocks sold off sharply, but they still were up or not down that much. You end the year with a small loss for large-growth and pretty big loss for small-value. Yet again, we have that tremendous difference in large-growth and small-value.

Benz: A question is, if people are looking at their portfolios, potentially doing some repositioning, is small-value potentially a place to take a look at?

Kinnel: I think so. I think generally rebalancing is valuable for that discipline because it forces you to invest in the areas that have gone down and the areas that may well be the cheapest. So, yeah, I think it's an attractive area. Obviously, it's been that way for a number of years. It's not like we can say, aha, now it's going to turn around today. It doesn't work that way.

Benz: I suppose another risk is that some of those small-value stocks are pretty cyclical and so, if we are headed into some sort of a broader economic downturn, they could feel some pain.

Kinnel: That's right. And it's no accident that in the last bear market we saw small-value do worse than large-growth. The previous bear market it was the other way around. Small-value was so cheap that even though it was exposed to the recession, they still did much better than large-growth. Large-growth got hit in turn because they have gotten priced so high. It's hard to say how it plays out the next time.

Benz: Every market environment is a little bit different. Let's talk about some mutual funds that performed relatively better. You said defensive funds, really across the board, even across asset classes, held their ground better than more aggressively positioned names. Let's start with fixed income. FPA New Income is one that you call out as having held up quite well.

Kinnel: FPA New Income is a fund that's really almost always on the defensive or nearly always in its life, and it's a fund that is particularly interested in protecting against both credit risk and rising interest rates. They've got kind of a quirky portfolio with lots of asset-backed securities but very much focused on protecting against rising rates and sure enough, we had interest rates rise and the fund held up really nicely. It's a fund obviously in good years you are unhappy because other funds have much better returns. But again, it's a very defensive fund and it shows at least that those defenses do work.

Benz: On the domestic equity side, one fund that you note performed quite well relative to its peers, that's Yacktman Fund. It had been through a spate of relatively weak performance but really was able to distinguish itself during this recent period of volatility.

Kinnel: That's right. Kind of like FPA New Income, it's a fund that is defensive enough that it tends to lag in bull markets. It's got kind of a high-quality/value tilt, but also, they tend to build a lot of cash when they don't find enough to invest in. And so, both of those things really worked for them. Obviously, cash is going to have a small positive return in just about any year, but also a lot of their quality names actually made a decent return last year. And so, after a number of years of lagging, the fund did really nicely in 2018.

Benz: Tweedy, Browne Global Value, another fund that we've long talked about as being relatively conservatively positioned foreign stock fund. It too did quite well.

Kinnel: That's right. In this case, they didn't have that much cash, but they did have quality names. And then, on top of that, they hedge their currency. And again, with the rising dollar that makes a really big difference. Again, being defensive in a slightly different way worked nicely for Tweedy.

Benz: Vanguard Global Minimum Volatility also performed quite well, as one would hope, during a period of market volatility.

Kinnel: This is a fund that owns a very wide array of stocks but again positioned toward the lower volatility, and it also hedges again with the idea that currency volatility is something that you can take out of the equation in order to produce a steadier return. And that's what they do and obviously, this was a year where it worked nicely.

Benz: Given all of these forces that are still out there worrying investors right now, I think it might be tempting to look at some of these very defensively positioned names and go fully on board with them. Would you recommend that or what should investors do as 2019 ramps up?

Kinnel: I definitely would not overreact. If you want to tweak your portfolio, maybe you have a really aggressive portfolio, then yes, some of these sorts of conservative funds that we talked about are good. But the rallies can be just as violent as the sell-offs. You don't want to be so positioned that you are not going to really participate in that rally. I think some of these conservative funds are nice. They can help you get through the rough times, but you don't want to completely overhaul your portfolio, because then you are really driving looking in the rear view mirror and that's not a good idea.

Benz: Really thoughtful recap, Russ. Thank you so much for being here.

Kinnel: You're welcome.

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