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5 Fund Downgrades and Dividends in Healthcare

We examine REITs and Wells Fargo, and, for retirees, tax-planning and volatility.

Editor's note: We are presenting Morningstar's Investing Insights podcast here. You can subscribe for free on iTunes.


Christine Benz: Hi, I'm Christine Benz from Morningstar. We devote a lot of attention to mutual funds that have received upgrades in their Medalist ratings, but we spend a little bit less time on the downgrades. Joining me to shed some light on some mutual funds that have recently been downgraded and what investors can take away from the downgrades is Russ Kinnel. He's Morningstar's director of manager research.

Russ, thank you so much for being here.

Russ Kinnel: Glad to be here.

Benz: Russ, let's talk about, generally speaking, some of the things that tend to trigger downgrades in Medalist ratings. What are the catalysts, typically?

Kinnel: Well, the most obvious one is a manager change. If you have really experienced manager who is key to our thesis and that manager leaves, that may well trigger a downgrade. Another one that's a little more subtle, and there isn't exactly an obvious trigger, is sometimes our conviction just erodes that over time, maybe we look close-- more closely--and and think, well, maybe our thesis isn't as strong or maybe it's simply a matter of performance not living up to, to what we had expected. Other times it can be rising fees, or even fees that don't move down simply because the rest of the industry is getting cheaper.

Benz: You mentioned performance, Russ. What kind of checks do you have against analyst sort of just looking at performance and extrapolating that it deserves a downgrade, because it hasn't delivered? How do you kind of check against that impulse?

Kinnel: Right. I think reading too much into recent performance is a mistake that almost every investor makes, including us. And it's something we try to guard against. And we try to work with the analysts. So, we try to look at it from a few different perspectives. One is long-term, we know that any active fund is going to have a one- or three-year downturn, even most passive funds for that matter, but active more dramatically. So, it's better to look at the longer record, but also to kind of, part of our thesis should be what kind of environment should this fund do well in? What kind of shouldn't do well in? And that should help to guide us.And is this really a change? Is this really failing to meet our expectations? So obviously, a more cautious fund, if it loses more the next two down markets, then that's going to worry us. So that kind of behavior. Or maybe it's a deep value fund. Deep value has a big rally, and it still doesn't do well. So those are the kinds of things we look for. So, it's not simply this fund has had a bad three years. We want to understand that context and want to understand the long-term record as well.

Benz: So let's go through some of the examples of funds that have recently been downgraded, starting with what you said is sort of an obvious catalyst for downgrades, which would be a manager change. This fund that recently saw a downgrade was T. Rowe Price Global Technology, manager change, talented manager moving on to another fund. Let's talk about the story there.

Kinnel: This was one of those moves where one manager leaves the firm, and you see a couple other moves triggered by that. In this case, Henry Ellenbogen left T. Rowe Price New Horizons. T. Rowe then promoted Josh Spencer from their global tech fund to the New Horizons fund. And at global tech, they promoted Alan Tu, who was an analyst in the tech area, but not one with management experience. So, in this case, you have a significant change with Josh Spencer, who had a very good record at the global tech fund moving on, and then Alan Tu with no record taking over. Obviously, there are still some strengths at T. Rowe, but we lowered the fund down to Neutral because you do have a new manager, and that really changes things.

Benz: Let's talk about an issue that you didn't discuss at the outset of the conversation: fees, and the role of fees in determining ratings. There were several several DFA funds that recently saw downgrades in part because even though fees look reasonable in absolute terms, you feel like they're really not keeping pace with some of their competitors. Let's talk about that.

Kinnel: So, fees are a huge component of our analyst ratings, because fees are the best predictor of future performance. And in a way, it's related to the performance discussion we had earlier, in that it's very easy for people to say, well, if this fund performed really well and overcame its high fee in the past, then it must be okay. So who cares about fees? But in fact, we know that, strong-performing funds in the past with high fees don't do so well. Now, the DFA case is more subtle. Here, they actually have relatively lower fees than most of their peers. But what's been going on in the industry is fees have been coming down. Active funds have cut fees, passive funds have cut fees. DFA views itself rightly as kind of in between active and passive. They don't track indexes. And they do have some modest tilts to their portfolios, but in other ways, they're kind of passive. They're not picking stocks, they have very diffuse portfolios, and they're priced accordingly kind of in between. But as the rest of the industry has cut fees, DFA has really stood pat. And so as a result, we've lowered a number of their funds from Silver to Bronze, because we think a little of that edge has gone away.

Benz: So, a couple of the funds on the list would be DFA U.S. Micro Cap and DFA U.S. Targeted Value.

Kinnel: That's right.

Benz: Let's talk about a couple of funds that you think kind of exemplify the "loss of conviction" story. This is PIMCO All Asset All Authority as well as PIMCO All Asset, Rob Arnott's well-known go-anywhere funds. Why have convictions diminished a little bit in these two?

Kinnel: Right, as you mentioned, Rob Arnott, who was just on your podcast, is a very thoughtful investor who's done some really interesting research in a variety of areas. But these are funds that you're really hiring for their allocation for some of their tactical moves. And we certainly understand that no one is going to get all of those right. But his two funds have consistently tilted the last decade toward emerging markets and towards value. And both of those tilts have been wrong over a decade. So that's obviously a pretty long time to be wrong. The All Authority fund we lowered all the way to Neutral, the All Asset to Silver. All Asset has more guardrails, All Authority has wider authority it hasn't used that well. It even has the ability to short and has at times been short the U.S. market, which has been a particularly bad move. So, we still think there are some merits, particularly to All Asset, but over time eventually you have to say, well, these moves haven't worked.


Damien Conover: When thinking about investing and thinking about dividends, one area we like to look at is the pharmaceutical stocks. These stocks tend to pay out a lot of their cash flows in dividends. And for the most part, dividends in the pharmaceutical landscape are fairly safe. Two names that we're highlighting today are AbbVie and Pfizer. Let's take them one at a time.

With AbbVie, this is a stock right now that's paying out a dividend yield that's almost over 6%. So very strong dividend yield and the valuation does look attractive. Now, the reason why there are some concerns about the stock is in about three to four years, they're going to lose patent exclusivity on one of their key molecules, called Humira. But the reason why we like to stock is they've got a great pipeline, and they've made a recent acquisition of Allergan to get even more products. So, you're looking at a much more diversified company. And even in the worst case, that dividend payout ratio only gets to about 65%. So, we think there's plenty of cash flows in the overall landscape for AbbVie to be able to pay out its dividend over the next several years.

The other stock that we like a lot from a dividend perspective, and from a capital appreciation perspective, is Pfizer. Pfizer doesn't have as much--doesn't have as much patent risk. And so you're going to look at much more stable cash flows for this company. You're looking at a dividend yield of over 4% and a pretty safe payout ratio as well. So, when we think about Pfizer, we think the thing that the market's really missing is the next-generation molecules that Pfizer's bringing to the market. They're really focused in oncology and immunology. And these are the two areas you really want to be focused in because you have very strong pricing power. We think as Pfizer brings out these next-generation molecules, the earnings will grow and the overall ability to continue to pay off the dividend will grow as well.

So, in summary, when we think about investing and we want dividend yield, pharmaceutical stocks are generally a great area to look at. And we think AbbVie and Pfizer are two good names to be looking at for both capital appreciation and dividend yield.


Christine Benz: Hi, I'm Christine Benz from Morningstar. Is a volatile market a disaster if it occurs early on in your retirement? Joining me to discuss that topic is Judith Ward. She is a senior financial planner for T. Rowe Price.

Judith, thank you so much for being here.

Judith Ward: I appreciate it. Thanks for having me.

Benz: So, let's talk about this phenomenon that retirement researchers call sequencing risk, the risk that in the years right after my retirement, the market drops a whole bunch. This is top of mind for today's retirees. Let's talk about why that can be so problematic, that sort of luck of the draw really about how the market performs.

Ward: Yeah, I think it can be problematic, because when you first enter into retirement, a lot of times you might be in retirement for decades, right? So that nest egg needs to last for maybe 20, 30 years, if not longer. And early in retirement, if the market goes down significantly, and you're drawing from your portfolio, then you've actually locked in these losses. So, the money you've withdrawn is never going to have the chance to recover. So, you're already taking money out of a portfolio balance that's depleted. And so, it could really kind of hurt this idea of your longevity throughout retirement and your money lasting.

Benz: So, you and the team at T. Rowe Price did some research on looking back at past downturns to see how a retiree would have done with a balanced portfolio employing the 4% guideline, so that 4% withdrawal initially with inflation adjustments on that dollar amount thereafter. Let's start with the early 70s period. This is, I think, where the 4% guideline actually originated, or that was the period that Bill Bengen looked at when determining, what is the most you could have taken out without running out of money. What was going on in the early 70s? Bad stock market environment?

Ward: Yeah, bad stock market environment, high inflation, which we haven't seen in recent memory, actually. But high inflation, bad stock market. And boy, I think the markets were down, I don't know, 30%, 40%, maybe more. But we did look at a balanced portfolio, because at T. Rowe Price, we think that that's the kind of portfolio someone at retirement should have. And we wanted to test the 4% rule to see, did it actually work. And we wanted to look at a 30-year, a full 30-year period, historical period. Of course, we also looked at more recent periods, but it hasn't been a full 30 years.

Benz: So, like the 2000s as starting point.

Ward: 2000, 2008, yeah, but it hasn't been a full 30 years.

Benz: Right.

Ward: So at first we wanted to look at a full 30 years where if someone retired in like 1973, what would have happened over those 30 years with just a consistent 60-40 portfolio? And we found that if they had started with the 4% of their balance and increased that amount based on the actual inflation at the time, they would have been fine by the end of 30 years.

Benz: So, even though it was high inflation?

Ward: Right, even though it was high inflation. However, a few years into retirement their portfolio would have dropped, I think, like 30%. So, imagine being in retirement for only three years, and seeing your portfolio drop--I think we started with a $500,000 portfolio--seeing it drop to under $300,000. I mean, that's pretty scary.

Benz: Yes.

Ward: And you're thinking, how is this going to last me for another two decades? And so, the assumption we made was, well, what if, at that point, because we know retirees adjust, they adjust their spending, what if they kept their spending flat? And how long would they have to keep their spending flat until their portfolio came back up, not to the entire $500,000, but came up to something that maybe they would be a little more comfortable. And we found that if they kept their spending flat for just a couple of years, they would have come out OK. And then, even later in retirement when the stock market took off, I mean, they actually could have spent a whole lot more money later in retirement and been fine. I mean, actually, it ended up that they had a lot of money at the end of that 30-year period because of the rebound. But just taking some, I think, smaller adjustments early on could really, I think, help to weather that early period of retirement.

Benz: So, in this case, a step that was actually pretty impactful was simply flatlining spending, not taking any sort of an inflation adjustment in the years in which the portfolio is depressed?

Ward: Correct. And even though we talk about flatlining or keeping spending steady, because inflation was high during that time, it probably did really mean a spending cut.

Benz: Yes.

Ward: Because they would have had to cut something to keep it flat. But they didn't have to make huge adjustments. And the other thing they didn't have to do was panic, and move their portfolio to cash, which would have really been detrimental for the rest of their retirement. So, just by taking these small adjustments--and we talk about as people head into retirement, I think it's really important to look at how you're truly going to spend your money. So, if you do need to make adjustments, you know where you might do that. I think that's a really important step prior to retirement. So, if something like that does happen, you know where you might take a little bit of a haircut in terms of spending, but just for a short time period. This ended up just two years that you had to kind of go through that.

Benz: So, the '73, '74 cohort of retirees, they were okay using the 4% guideline, maybe modified a little bit. The 2000s retirees retiring into that dot-com bust, they're also doing OK. But they're only 19 years in, so we don't truly know.

Ward: Right.

Benz: I guess the issue, though, is that past is not prologue, right, that the environments that prevailed in these two periods may not be the type of environment that we encounter going forward. So, let's talk about how retirees can take control of the next down market that materializes. So, maybe I am that early retiree--or the retiree who just started and I happen to hit this Armageddon of a market environment, what steps can I take to preserve my plan? It sounds like maybe being willing to be a little bit flexible about my spending. What else?

Ward: Yeah, and we think that, during times of market volatility, it's important to focus on the things you can control. And one of the things you can control is your asset allocation. Now, maybe there's people that have just enjoyed this run-up, you know, this bull market, and they've just let their portfolio run. So, they might be overemphasizing stocks. Now would be a good time before it hits to just think about your asset allocation. When we look at different asset allocations, we looked at an 80-20 stock portfolio, a 100% stock portfolio, and these were just broad indices to represent the portfolios, and how they did in 2008. And so, an 80% to 100% stock portfolio was down like 30% to 40%.

So, you have to ask yourself, if that were to happen--and that's probably a worst-case scenario--but if that were to happen when I'm in retirement, or at any point, would that impact my lifestyle? Would that truly impact my lifestyle? And if the answer is yes, then you probably want to de-risk a little bit or get into that more of a balanced type of portfolio, so you're not experiencing that degree of a short-term loss, especially when you might be taking money out of your portfolio. So, that's something you can control, is your asset allocation.

Another thing you can control is your spending. And that's where I just talked about, knowing what you're going to be--being able to adjust your spending. Another thing you might want to consider is this idea of a cash contingency, starting to build up some money on the side. Again, we looked at these portfolios and how they recovered. And in the Great Recession, a stock portfolio took almost five years to recover, a 60-40 portfolio recovered in two years. So, maybe you have up to two years of your spending need in this cash contingency or this sleep-at-night money, so that it's an alternative to draw from if you feel like you really don't want to touch your portfolio at some point in time over the short time period.

Benz: Judy, always great advice. Thank you so much for being here.

Ward: Thank you.

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


David Kathman: Real estate funds can be useful in just about any portfolio, especially as a diversifier. That’s because the returns of real estate stocks tend not to be too strongly correlated with the returns of either the broader stock market or with bonds. 

Just to give a couple of examples, in 2013 the S&P 500 gained 32%, while the Barclays US Aggregate Bond Index was down 2% and the MSCI US REIT Index of real estate stocks was similarly flat, up just 1%. But then in 2014, the MSCI US REIT Index gained 29%, while the S&P 500 and Barclays Agg had much smaller gains, of 14% and 6%. So having a modest real estate position in your portfolio, say 5% or 10%, can help smooth out returns and ultimately lead to better results over the long term. 

As for how to get that real estate exposure, there are a few pretty good options. Vanguard Real Estate Index is by far the largest real estate mutual fund with about $68 billion in assets, more than half of which is in the ETF version. As its name suggests, it’s an index fund that tracks a broad benchmark of real estate stocks, and as you would expect from Vanguard, it’s also very cheap, costing 0.11% for the Admiral shares and 0.12% for the ETF.

DFA Real Estate Securities is another cheap fund in this niche, at 0.18%. It’s not technically an index fund, but like other DFA funds it uses a rules-based approach that results in index-like returns. 

The Vanguard and DFA funds are the only funds in the real estate category with Morningstar Analyst Ratings of Silver, but there are quite a few Bronze-rated funds in the category that are actively managed. Some of the more prominent ones are Fidelity Real Estate Investment, Cohen & Steers Realty Shares, and Principal Real Estate Securities. They’re not as cheap as the passive funds I mentioned, but they all have long-tenured managers and strong track records, and they’re all pretty solid ways to get real estate exposure for a portfolio.


Eric Compton: We recently performed a deep-dive analysis on Wells Fargo, as this has been one of the most controversial names under our banking coverage. After going through this exercise, we still think Wells looks cheap compared to our updated fair value estimate of $58, but we don't view shares as a steal, either.

Overall, we think many investors have fundamentally misunderstood what has happened to Wells over the past several years, as they have tended to equate the bank's lower profitability with the sales scandals. Rather, we think that changes in the mortgage market, the sell-off of pick-a-pay loans, and changes to deposit pricing have been the primary causes of Wells' declining profitability, and we don't see Wells churning out the high-teens returns on tangible equity that the bank was once capable of.

Even so, we see no reason why the bank can't consistently hit a 14% return on tangible equity, which should warrant a higher valuation, and this is the essence of our thesis. We believe the bank still has the right pieces in place within its community banking, wholesale banking, and wealth and investment management segments to compete effectively over the long term.

We certainly do not want to dismiss the effects of the sales scandals, and in fact, we still see a rocky road over the medium term as the bank likely faces the asset cap for another year, likely has another wave of fines, and faces a less-than-ideal CEO situation. It will also take years to fully ingrain a new culture.

For investors who understand the risks, the bank provides an attractive dividend yield, has the ability to repurchase substantial amounts of shares, and we believe the bank will eventually figure it out on the operational side, although how long it eventually takes is another risk investors need to be aware of.  


Susan Dziubinski: Hi, I'm Susan Dziubinski from It's hard to believe it's already fall. And that means the fourth-quarter tax-planning season will be here before you know it. Joining me to share some items that retirees should have on their radar in this year's final three months is Christine Benz. She's Morningstar's director of personal finance.

Christine, thanks for joining us today.

Christine Benz: Susan, it's great to be here.

Dziubinski: Now, we're talking about the tax returns that we're going to be filing in April 2020. So why are we talking about tax planning now?

Benz: The issue is that you really have to make your moves to reduce your tax bill in that tax year. So, if we're talking about the return we'll file in April of 2020, well that's for the 2019 tax year. So, if we're going to take any steps to try to lower our tax bill, most of them--with a few small exceptions, like IRA contributions--need to happen in 2019 itself.

Dziubinski: One of the most pressing issues or topics that's top of mind for retirees is required minimum distributions. And you've talked about before how retirees can use RMDs to improve their portfolios. What do you mean by that?

Benz: Well, retirees love to hate their RMDs. Especially a lot of our audience where you've got affluent people, they see that their RMDs cause their tax bills to go up. But the way that you can use RMDs--required minimum distributions--to your benefit if you're subject to them, is to take a look at your portfolio and use the RMDs to withdraw from those assets that were problematic for one reason or another. So, a common situation right now is many retirees are probably a little bit equity-heavy in their portfolios relative to their targets. So, use the RMDs to derisk the portfolio in that spot, pull from that portion of the portfolio or maybe you have some holding that for whatever reason is just problematic. You've had a manager change, for example, and you're not that enthused about it. Well pull your RMD from that fund instead. Use it to improve your portfolio.

Dziubinski: Now, there's also a technique that charitably minded retirees can use that relates to RMDs, right?

Benz: That's right, this is such a great technique. It's called a qualified charitable distribution. And the basic idea is that you can pull up to $100,000 from your IRA, steer it directly to the charity or charities of your choice. And so this is the RMD amount that you otherwise would have taken and spent or reinvested somewhere, you're sending that RMD directly to the charity of your choice. And the benefit is that it doesn't affect your adjusted gross income--it goes directly to the charity. So, it's a particularly great strategy in light of the fact that with the tax law changes, many fewer taxpayers, retirees or otherwise, will be deducting--itemizing their deductions. And so that means that they won't be able to have their charitable contributions count toward that itemized deduction. The QCD, or qualified charitable distribution, is a way to get that charitable giving working for you from a tax standpoint.

Dziubinski: Let's pivot a little bit towards retirees who aren't yet tapping into their, taking their RMDs, and with the tax law changes, what do they need to know sort of about charitable giving now?

Benz: Well, it's trickier because many fewer taxpayers are itemizing. And so one strategy, especially for people who are giving significant amounts to charity is to use what's called charitable bunching, or charitable clumping. And the basic idea is that you are being really deliberate about your charitable giving. You are saving up your contributions and using them in years when you will, in fact, be itemizing. So rather than giving year after year, and giving smaller amounts, you're giving larger amounts in single years and getting some bang for your buck in terms of being able to itemize them on your tax return. The standard deduction, the higher standard deduction, makes itemizing less attractive for many taxpayers at this point. But if you do cluster those charitable gifts together, you may be able to get over that standard deduction threshold.

Dziubinski: Now, what are some other things that retirees need to keep in mind regarding other deductions that maybe they used to be able to take, that they're not able to take anymore?

Benz: Well, that's the tricky part. There are a lot of deductions that may go by the wayside because your standard deduction is higher than you can get with your itemized deduction. My advice is to still save all those receipts for your healthcare expenses, for your property tax outlays, all of the things that may be subject to caps. For example, save it all and take a good look at it at the end of the year. You may be surprised that you're able to exceed the standard deduction thresholds. Don't assume that the higher standard deduction means that you don't have to save those receipts. I would save them and take a tally of what your itemized deductions look like.

Dziubinski: Another ritual in the fourth quarter, usually in December, is what we call mutual fund capital gains distribution season, and they haven't been too pleasant the past couple of years. What do you--what do you think we should be looking for expecting this this year?

Benz: Well, I think it probably will be another tough year, Susan, because a lot of the trends that have fueled these big capital gains distributions are still in place. So namely, you've had a generally pretty good equity market and you have funds, actively managed funds in particular, that have been seeing big redemptions as we've seen investors moving to passively managed products. The net effect of that is that for investors and taxable accounts, well, they've been getting these big capital gains distributions that in turn they own taxes on. I would expect that the 2019 tax year won't be a lot better than what we've seen in the recent past. But I would also urge investors to check their cost basis. If they own one of these, I call them a serial capital gains distributor where you've got a fund that's been doing this year after year.

Well you have been getting a step up in your cost basis to account for the fact that you've been getting this capital gains distribution, and you've had to pay taxes on it. So, you may find actually, when you look at your adjusted cost basis, the things look better than you might think. And that it might not be that bad an idea to sell the holding, if you wanted to sell otherwise, the tax burden associated with selling may not be all that terrible. So, take a look at that, that might be at least a small silver lining if you have had to contend with some of these big distributions in the past.

Dziubinski: So is there anything that we can be doing to lessen the tax pain?

Benz: Well, sometimes investors, try to get preemptive if they see one of these capital gains distributions coming, they might sell preemptively. That can make sense, actually if you wanted to sell the position otherwise, but again, remember that you're contending with two sets of tax costs. One is the distribution and the taxes due upon it. The other is the taxes that are due on your own sale of the security. So again, check your cost basis, if you've been getting the adjustments, selling may not be such a bad idea after all.

Dziubinski: Well, Christine, thank you very much. It does make sense to be talking about taxes now rather than waiting until April, so we appreciate it.

Benz: Thanks, Susan.

Dziubinski: From I'm Susan Dziubinski. Thanks for tuning in.