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Rekenthaler Report

Did Mutual Funds Perform as Expected During the Mini-Crash?

For the most part, yes.

Editor’s note: Read the latest on how the coronavirus is rattling the markets and what investors can do to navigate it.

Open Questions
It’s no secret that the S&P 500 dropped 11% last week. Less discussed has been how that downturn affected funds. Did any stock fund categories escape the damage? Did bond funds and alternative funds protect against the carnage? Should 401(k) investors be pleased with their target-date funds? Finally, how did active equity funds fare?

A Strange Refuge
There weren’t any domestic-stock escapes. Everything went down by roughly the same amount. The same pattern largely held in 2008, aside from “wide moat” stocks (Morningstar’s term, purloined from Warren Buffett; the company steals only from the best), which lost about two thirds as much as the overall market. This time around, moats were no protection. The 10 mutual funds with the most exposure to wide-moat stocks also declined 11%.

The only relief came from international portfolios, as most overseas markets held up better than did the United States. Ironically, the leading category was ... China region stock funds, which shed a modest 4%. (If you had guessed that funds that invest in the birthplace of the coronavirus would be the best performers during a global downturn that was caused by fears of the coronavirus, congratulations!) Other Pacific markets, including Japan, weren’t too far behind.

Initially, I thought these differences owed to time-zone disparities. Not so. True, domestic stocks plummeted on the week’s final weekday, Feb. 28, meaning that if foreign equities followed suit (as they usually do after a U.S. sell-off), the weekly comparisons would be skewed. Early Monday, however, the Bank of Japan kick-started a global rally by promising to support asset prices. Those big Friday U.S. losses did not follow through to other major markets.

I’d like to believe that foreign equities at long last provided diversification, but that seems unlikely. The coronavirus, after all, operates internationally. Any performance differences from short-term timing will likely disappear over the long haul. There’s not much to be learned by the fact that, in this downturn, Chinese equities offered relative safety.

Bonds & Alternatives
Bond funds provided few revelations. Recession fears typically spark a flight to quality, thereby boosting Treasuries. The long-government bond category duly responded, gaining almost 5%, thereby becoming the week’s second-best performer. (Bonus points if you can guess the leader, which I will divulge shortly.) The more popular intermediate-term bond categories each made about 1%. Not enough to save a portfolio, but better than losing money.

The only real news among bond funds was that, despite heavy redemptions, high-yield bond funds held up well. Sometimes junk bonds are sharply affected by stock market declines, other times not. Last week was not, as junk-bond funds lost less than 3%. That this performance occurred even as headlines warned about the damage that might arise from exchange-traded fund redemptions is one more reason not to take such cautions to heart. Researchers can readily measure fund flows, but they can only speculate flow effects.

Whether alternative investments surprised depends upon one’s view of alternatives. Those who believe that alternatives zig when stocks zag will be disappointed. On the other hand, skeptics like me who fear that alternatives will never live up to their advertising will be psychologically comforted. We expect little from alternatives; we received little; all seems as it should with the world.

The broadest and most representative alternative category, multialternative, dropped almost 4%. Managed futures fared somewhat worse, long-short equity was lower yet, and anything related to commodities got smacked. On the bright side, market-neutral funds were barely negative (then again, they barely profit when stocks rise), and bear-market funds were runaway winners, gaining 16%.

Unfortunately, almost nobody owns bear-market mutual funds, which in aggregate possess only half a billion in assets, so it’s not as if those investments were helpful in practice. Once again, par for the alternatives course.

Deliberately Dull
Target-date funds were roundly criticized for their 2008 results. Since then, many of that year’s biggest losers have liquidated, while others have become more conservative, either by reducing their stock weightings or by upgrading the quality of their bond portfolios. Today’s target-date funds are beige. They are managed toward the middle, hoping never again to attract the spotlight.

In that goal, they have been successful. The target-date categories performed remarkably unremarkably, so to speak, by closely tracking the totals for similarly structured allocation categories. For example, target-date 2040 funds hold an average of 79% in equities, as opposed to a 76% position for the allocation--70% to 85% Morningstar Category. (The clunkiest name that Morningstar has coined but marvelously descriptive.) The two groups posted almost identical losses.

Returns within the target-date 2040 category were notably bunched. More than 90% of the group’s funds lost between 7% and 9.5%. The entrants from industry leaders Vanguard, Fidelity, and T. Rowe Price were even more tightly clustered, landing within a 50-basis-point range. Relatively speaking, the news about target-date funds was no news at all.

Actively Hoping
Eh, no. The beginning of this column reveals its conclusion. If all domestic-stock fund categories behaved similarly, active funds in aggregate were destined to track their relevant indexes. They couldn’t benefit by favoring particular sectors or investment styles. Nor could they time the downturn, because most stock funds these days are committed to being fully invested, and even the exceptions haven’t shown much ability to avoid bear markets.

Thus, active funds from the three large-company stock categories finished between 24 and 37 basis points ahead of their index-fund rivals, meaning that they effectively matched them. (Their slight advantage owed primarily to their cash positions.) The prevailing narrative therefore remains unchanged. Index blue-chip stocks--because the cost advantage will ultimately prevail and because active management hasn’t delivered on its vow to beat index funds when the going gets tough.  

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.