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Did the Pandemic Change How Fund Managers Think About Risk?

They have varied in their response to COVID-19.

When the novel coronavirus pandemic hit the United States in March 2020, it upended society and roiled financial markets in unprecedented ways. After much of the country was shut down, the resulting disruption caused the sharpest economic contraction in decades. The stock market fell more than 30% in a matter of weeks, but then rebounded quickly thanks to massive fiscal and monetary stimulus, making it the shortest bear market on record. The announcement of effective coronavirus vaccines in late 2020 caused many of the stocks hit hardest by the pandemic to rally sharply, but that rally fizzled several months later when it became apparent the reopening of society might not be as quick or as seamless as many expected.

The market’s sudden and unexpected drop naturally rattled a lot of investors and forced them to think about the possibility of another big dislocation in the future. Morningstar’s Manager Research analysts have recently asked a number of mutual fund portfolio managers how the pandemic has affected the way they think about risk, especially downside risk. None of the managers we spoke with have made any major changes to their processes because of COVID-19, but they’ve all thought about it quite a bit, and the way they looked at it depends to a large extent on the kind of fund they run.

For example, Todd Beiley of Virtus KAR Small-Cap Growth PXSGX said the pandemic hasn’t changed his thinking on downside risk, which has long been of central concern. He and his team have always focused on finding small-growth companies that are durable and have strong balance sheets, and thus are capable of doing relatively well in downturns. That focus helped the fund hold up well in the 2008 bear market relative to its small-growth Morningstar Category peers, and the same was true in last year’s pandemic bear market, when its peak-to-trough loss of 32% was much better than the 40% loss of the Russell 2000 Growth Index.

Similarly, Scott Tracy, lead manager of Victory RS Small Cap Growth RSEGX and Victory RS Mid-cap Growth RSMOX, looks for growth stocks with high returns on capital and low debt, where the potential return outweighs the potential loss by a factor of 2 to 1. Tracy and his team reassessed their investment theses for all the funds’ holdings when the pandemic hit, but they didn’t make many changes, as they see the stocks they hold as being well-suited to market downturns. Victory RS Small Cap Growth lost modestly less than its small-growth category peers in the 2020 bear market and outperformed the category for 2020 as a whole.

In contrast, Hennessy Focus HFCSX is a mid-growth fund with a lot of exposure to cyclical stocks, many of which have lots of debt on their balance sheets. It got hit hard in the bear market of early 2020 and was one of the category’s worst performers for 2020 as a whole. Yet when the managers reevaluated all their holdings after the pandemic hit, they concluded that the fund was in good shape and no major changes were necessary. The managers aim to hold industry leaders run by thoughtful management teams, and the portfolio still fit that bill. This patient approach was painful in the short term, but the fund was one of the best-performing mid-growth funds in the first nine months of 2021.

All of the growth funds mentioned above basically stood pat when COVID-19 upended the markets; their managers still liked their stocks as long-term holdings, so they held on to those stocks and weathered the storm. On the other hand, value fund managers were much more likely to see such a big market drop as a buying opportunity. The managers of VY American Century Small-Mid-cap Value IACIX certainly viewed the pandemic that way. Like the funds noted above, this fund held up relatively well in the downturn, thanks to its holdings’ strong balance sheets. The managers had stress-tested their valuation models and correctly figured that the stocks could weather the crisis in good shape. But unlike the managers of those growth funds, here comanager Jeff John saw the downturn as a chance to buy stocks that had gotten cheap as a result of indiscriminate selling. Several of the stocks the fund bought early in the pandemic have posted big gains, such as Cimarex Energy CIMXP and Skyline Champion SKY.

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