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Third Quarter in U.S. Stock Funds--A Mixed Bag

Investors remained cautiously optimistic despite looming threats and rocky markets.

The prominent investment themes from the second quarter leaked into the third, producing volatile trading but little movement. The U.S.-China trade conflict captured investors’ attentions and seesawed markets, while the Federal Reserve lowered rates for the second time this year in September. That, combined with slowing global economic growth, produced an inverted yield curve, which can be a harbinger of economic downturns. In all, the S&P 500 pushed 1.7% higher for the quarter through Sept. 26, while the smaller-cap Russell 2000 Index lost 1.8%. And despite the muted returns, domestic equities outperformed their foreign counterparts yet again. The Russell 3000 Index has now beaten the MSCI ACWI ex USA Index in nearly two thirds of the past 40 quarters.

Two other broad trends continued in the third quarter, with the Russell 1000 Growth Index beating its value equivalent and large-cap benchmarks besting their smaller peers. Morningstar Category averages, however, exhibited different tendencies. The average large-value fund gained 1.3%, topping the large-growth norm by more than a percentage point and even the Russell 1000 Value Index by 11 basis points. Sector allocations may explain some of the divergence. The average large-growth strategy owned less of the strong-performing technology sector relative to the bogy, while the average value fund owned more tech. Higher yields also bolstered value strategies. Large-blend’s 1.5% return led the nine equity Morningstar Style Box categories, while small-growth lagged, losing 3.5%.

Looking back, the week of Sept. 9 appears unremarkable as the S&P 500 gained 1%. Yet there were signs of an underlying shift. Value stocks trounced growth--the Russell 1000 Value Index outperformed its growth sibling by 2.9 percentage points--spurring speculation that the long-awaited rotation to value was at hand. Only hindsight will tell; until then, that five-day stretch serves as a reminder of how difficult it is to predict such shifts and how quickly value can make up lost ground. Over the trailing 12-month period through Sept. 26, for example, domestic value indexes were beating their growth rivals owing in large part to value’s outperformance in 2018’s fourth-quarter correction. Yet the Russell 1000 Value Index’s 11.5% annualized return over the past decade still lags its growth counterpart by 3.5 percentage points.

Hartford Dividend and Growth (IHGIX), which has a Morningstar Analyst Rating of Silver, outperformed the Russell 1000 Value Index for the quarter. Its 3.3% return through Sept. 26 beat the bogy by 2 percentage points. Edward Bousa of subadvisor Wellington Management has been lead manager on this strategy for almost two decades. And although he’s set to retire in June 2020, his prudent approach strikes an effective balance between total return and yield. The Fed’s decision to cut interest rates in June and September made stable, higher-yielding names such as telecoms giants AT&T (T) and Verizon Communications (VZ) and consumer staple Kellogg (K) more attractive. Bousa also invests 20% of the portfolio in growth names such as Alphabet (GOOGL1), which returned 14.7% for the quarter through Sept. 26.

Neutral-rated Royce Premier’s (RYPRX) 19% return for the quarter outpaced 97% of small-growth category peers. The fund shuns the healthcare sector, a drawback that hinders its Morningstar rating, but its trivial stake there helped investors in the third quarter as the sector lagged every other except energy. Stock selection also generated strong returns, although not in the sector one would expect. The managers’ high-conviction approach leads to a heavy overweighting in industrials (34% versus 16% for the Russell 2000 Index), but much of the outperformance came from names outside the sector, such as semiconductor firm Cabot Microelectronics , software developer Manhattan Associates (MANH), and Canadian mortgage insurer Genworth MI Canada .

Niche investments led all equity strategies for the quarter. Franklin Gold & Precious Metals’ (FGADX) 13% gain for the quarter through Sept. 26 led the equity precious metals category. Surging gold prices benefit the Neutral-rated strategy’s portfolio, because the returns of the gold miners it owns correlate with the underlying commodity. The fund’s 37.7% year-to-date return more than doubles the price return of gold. Bronze-rated Cohen & Steers Institutional Realty Shares (CSRIX) gained 9.8% for the quarter through Sept. 26, finishing in the top decile among real estate peers. The strategy’s hefty yield appeals to income-starved investors following the Fed’s second rate cut of the year. Indeed, its 3% yield is 1.0 and 1.3 percentage points higher than that of the S&P 500 and 10-Year Treasury, respectively.

Primecap Odyssey Aggressive Growth's (POAGX) recent woes continued, as it lost 5.6% in the third quarter through Sept. 26. Its 11.7% loss over the past 12 months finished in the bottom decile of the mid-cap growth category. This isn’t out-of-character for this Gold-rated fund, though. Its multiple managers build a portfolio of 130-150 stocks that still courts stock- and sector-specific risk. Top holdings Abiomed and Nektar Therapeutics (NKTR), two smaller-cap healthcare names, have hindered returns. The FDA questioned the efficacy of one of Abiomed’s heart pumps in February, then the company missed earnings estimates in August; both events sent the stock plummeting. Nektar Therapeutics’ share price cratered after the company revealed manufacturing issues with its experimental cancer drug. Both stocks have propelled the fund’s strong results in the past, though.

Oakmark Select (OAKLX) and Hotchkis & Wiley Mid-Cap Value (HWMIX) both finished at the bottom of their respective large-blend and mid-value categories owing in part to their energy sector exposure. Initially, oil prices and energy stocks fell because of a combination of an oil supply glut and lower forecast demand. Then, security concerns and geopolitical tensions further roiled the commodity’s price (more on that below), making energy the worst-performing sector for both the quarter and year to date.

The sector has hurt the two funds in different ways. Lead manager Bill Nygren of Silver-rated Oakmark Select builds a very concentrated portfolio that amplifies successes or missteps. So, though Nygren hasn’t made big bets in the sector, poor selection has sunk its returns. Forays into energy-price-sensitive oil & gas exploration and production stocks like Concho Resources and Apache (APA) have proved ill-fated thus far. Their struggles compound Nygren’s recent difficulties in the sector, as holding Weatherford International went bankrupt earlier this year.

Bronze-rated Hotchkis & Wiley Mid Cap Value has much more energy exposure to the sector: one fifth of its assets. Specifically, helpings of oil & gas equipment and services names, such as Superior Energy Services and McDermott International , have curbed performance.

These two funds’ pain can quickly become their gain. When oil prices leapt after a Sept. 14 attack on a Saudi Arabian processing facility, so did these funds. Even after oil prices receded, both funds remained in the top decile of their respective categories for the month of September.

Oakmark also rued a 4.4% stake in Netflix (NFLX) in the quarter, but Neutral-rated Touchstone Sands Capital Select Growth (TSNAX) had it worse. Netflix is the fund’s fifth-largest holding at 6.4% of assets, and the video streaming service’s 28.3% loss for the quarter helped the strategy’s quarterly results rank behind 96% of its peers. Netflix announced a rare loss in U.S. subscribers in July. Then, several firms, including Walt Disney (DIS), Comcast (CMCSA), AT&T, and Apple (AAPL), outlined plans for competing streaming services that could eat into the company’s dominant market position.

Tom Nations has a position in the following securities mentioned above: POAGX. Find out about Morningstar’s editorial policies.