22 Downgrades for 2019
Kicking funds when they are down.
The following was published in the September issue of Morningstar FundInvestor. The Morningstar 500 is the list of funds tracked in FundInvestor.
We have downgraded 22 funds in the Morningstar 500 so far in 2019. So, at the risk of being a downer, I'll go through those funds and our reasons why.
As you know, our Morningstar Analyst Ratings are driven by fundamentals that affect long-term performance. We aren't making short-term calls. Rather, we are evaluating managers, analysts, parent companies, investment strategies, and fees. How all those things come together drives our overall rating. Another way of looking at it is that we are assessing a fund's competitive advantages and deciding whether they are sufficient to overcome the fund's fees in delivering strong long-term, risk-adjusted performance.
Most of our downgrades fall into three buckets. One is manager changes. No surprise that losing a talented manager or managers could spur a downgrade. A second is that failures in execution of strategy over a long period erode our belief in a fund, and we decide that its competitive advantages are not so great after all. A third is that by standing still, a fund's competitive advantages have eroded relative to peers who have raised their games. After all, that's how markets work.
Other reasons that don't feature in this year's downgrades but can have an impact are growing problems at the parent company or rising expense ratios. As you review the downgrades, I suggest taking particular note of those that were lowered to Neutral, as that means they have been dropped from our recommended group. Also, remember there's a more complete analysis of these fund's prospects if you click through to the full analyst report.
Making macro calls is difficult. No one gets them all right. But they should get some right, and Research Affiliates has been on one heck of a wrong streak. The firm's discipline is to overweight markets that appear cheap and underweight those that seem overpriced. It also has a built-in value tilt. For the past decade, PIMCO All Asset All Authority (PAUAX) and PIMCO All Asset (PASAX) have been massively overweight in emerging markets and underweight in the United States. So, they've gotten their biggest call wrong, and the value tilt has hurt, too. PIMCO All Asset All Authority has greater latitude for macro calls, and that's been a bad thing, so we lowered it to Neutral from Bronze and PIMCO All Asset to Silver. It would take the mother of all reversals for the funds' anti-U.S. tilt to be right or even neutral relative to emerging markets, so clearly their models are not as good as we once thought. On the plus side, the funds use PIMCO's excellent bond-fund lineup for their fixed-income allocations.
Loomis Sayles Strategic Income (NEFZX) still has a lot to offer, but it takes some big idiosyncratic risks relative to its peers, and that led us to downgrade the fund to Bronze from Silver. The fund has quite a bit of nondollar exposure, and that's held it back while increasing volatility. In addition, the fund has had sizable equity stakes featuring big individual stock bets. That equity weighting has helped returns, but again it has heaped on additional risk. Investors generally don't buy a bond fund expecting large equity risk, but the fund has had double-digit equity weightings and individual stock positions approaching 5% of assets under management.
Similar concerns about equity and nondollar exposure led us to cut sibling Loomis Sayles Bond (LSBRX) one notch to Silver. Obviously, our conviction levels didn't erode that much, but we thought unusual risks such as a 9% equity weighting at the end of June merited a Silver, even though we still liked the team and other aspects of its process.
American Century Value (TWVLX) has fallen a notch in our estimation because of a few issues. Manager Michael Liss has shifted toward deeper value at a time when the market favors growth. The fund had outperformed the Russell 1000 Value Index over Liss' first seven years on the fund, but a four-year slump has pushed it below the index. On top of that, the fund has lost some analysts, and its expense ratio has held to a somewhat pricey 0.98% even as the competition got cheaper. We cut the fund's rating to Bronze from Silver.
Gateway (GATEX) was downgraded to Bronze from Silver because the competition has gotten better and it disappointed in the fourth quarter of 2018. The fund is meant to be defensive, yet it lost 7.5% in the fourth quarter. But more generally, the fund's simple use of put options on the S&P 500 (financed by selling at-the-money calls) has been surpassed by competitors in recent years. We still like the simplicity of the fund, but Bronze is a better measure of the fund's appeal.
Sammy Simnegar is moving from Fidelity Emerging Markets (FEMKX) to Fidelity Magellan (FMAGX). Now that's quite a shift. The move was announced on Feb. 22. Simnegar will leave Oct. 1, and John Dance, whom Fidelity made a comanager on Feb. 22, will become lead manager. At Fidelity Emerging Markets, Simnegar has employed an unusual style that will surely change significantly under Dance. Dance has run other Fidelity regional funds, but he will be taking over a much larger fund. Exactly how Fidelity Emerging Markets will change under Dance is not clear, so we're lowering the fund's rating to Neutral.
Fidelity is also losing a key manager on the bond side of emerging markets. Fidelity New Markets Income's (FNMIX) John Carlson will step down at year-end and hand the reins to two very experienced investors in Jonathan Kelly and Timothy Gill. We expect the strategy to stay in place and have cut our rating one notch to Bronze.
T. Rowe Price Global Technology (PRGTX) may have been too successful for its own good. When T. Rowe Price New Horizons (PRNHX) manager Henry Ellenbogen surprised T. Rowe Price by quitting, the firm moved Josh Spencer to New Horizons from Global Technology and promoted analyst Alan Tu to fill Spencer's shoes at Global Technology. It's a big challenge for both Spencer and Tu at their new charges. It's Spencer's first diversified fund and a much larger one than Global Technology, and it's Tu's first fund. Both funds got two-notch downgrades. Global Technology fell to Neutral and New Horizons to Bronze.
T. Rowe Price High Yield (PRHYX) is having a slower, more orderly transition. Mark Vaselkiv will step down on Jan. 1, 2020, and Rodney Rayburn will take his place. Rayburn has run T. Rowe Price Credit Opportunities (TCRRX) since 2015. It's a big step up in size for Rayburn and a different mandate. Still, he does have experience and the fund has the benefit of a strong team of high-yield analysts. We cut the fund to Bronze from Gold.
BBH Core Select (BBTEX) lost a manager, and that opened the floodgates for redemptions. That put manager Michael Keller in a tough spot and led us to downgrade the fund to Bronze from Silver. After we downgraded, BBH announced it would liquidate the fund in October.
BlackRock Global Allocation (MDLOX) lead manager Dennis Stattman retired in 2017, and then, this year and next, two more managers are departing. Although some good people remain on the fund, we have lowered our rating to Bronze from Silver.
Artisan International Value (ARTKX) and Artisan Global Value (ARTGX) each lost a good manager when Dan O'Keefe and David Samra parted ways. Now O'Keefe runs Global Value, and Samra runs International Value. The pair split up analysts, too, so there's been a drop in analyst support for the funds. Still, we like the managers and strategies, so we took the funds down only to Silver.
Mairs & Power Balanced (MAPOX) went from a very experienced lead manager to one with a more modest amount of experience, prompting us to cut the fund one notch to Bronze. In June, Ron Kaliebe retired and Kevin Earley replaced him. Earley has a little over four years' experience as comanager here.
We love the long-range notice provided by MFS Value (MEIAX) on its pending manager change. MFS said veteran manager Steven Gorham is going to step down from the fund at the end of 2020, leaving comanager Nevin Chitkara in charge. (Gorham is going to focus on some MFS allocation funds.) The firm will promote Katherine Cannan to manager at the end of 2019. While we like the planning, we can't ignore that losing Gorham takes the fund down a bit. Chitkara has been a comanager since 2006 and a key contributor, so we still have conviction in the fund. MFS' analysts are also a key part of the appeal that isn't changing. Thus, we're taking the fund down to Silver from Gold.
Passive Funds Lose Their Edge
DFA has long straddled the line between active and passive. It doesn't pick stocks, but it doesn't track an index; it does have slight factor tilts, and it trades opportunistically so that it can benefit from small-cap bid-ask spreads rather than suffer from them. DFA thinks it should charge fees that are in between active and passive, so when other true index funds cut their fees, DFA didn't follow suit. Of course, that makes the cheaper index funds more attractive relative to DFA. Thus, we lowered four DFA funds one notch.
Fidelity Four-in-One Index (FFNOX) is still super cheap, but it makes less sense since Fidelity lowered the minimum investment on its institutional-priced index funds. This fund looked like a bargain by charging 8 basis points for a combination of four funds, but now that you can get them directly and choose your own asset mix, this fund is solving a problem that no longer exists.
So, Your Fund Got Downgraded
What should you do if your fund got downgraded? Remember that all Morningstar Medalist ratings are set at a recommended level. We don't know what's right for your portfolio, but if we maintain a fund at the medalist level, we think the fund has a good shot at outperformance.
Begin by thinking about why you own the fund and what role it plays in your portfolio. If your thesis or selected role in portfolio no longer works, that is a good reason to sell. On the other hand, if your thesis is intact and the fund still fulfills its role, you might want to hold on.
If you think you want to sell, you should consider what commissions and taxes you would have to pay to get out. For example, making changes within a 401(k) or IRA might be free of those costs, but a taxable account might not. Finally, examine the better options for a replacement and whether they amount to a sufficient-enough upgrade to justify a move.
Russel Kinnel has a position in the following securities mentioned above: LSBRX, ARTGX, PRHYX. Find out about Morningstar’s editorial policies.