Should You Dump That Slumping Fund?
One of the hardest decisions for fund investors is whether to stay with a slumping fund.
This article was originally published in the December 2018 issue of Morningstar FundInvestor. It has been updated to reflect returns and other changes through January 2019. Download a complimentary copy of FundInvestor by visiting the website.
It’s been a rewarding but tricky time to invest. Fund managers who tend not to invest in technology and healthcare have had a very hard time keeping up with their benchmarks and peers. Some funds are way back in the pack.
That presents a challenge for fund investors. You have to figure out if your fund’s slump is temporary or if it will continue for years. At Morningstar, we dig to find out if the slump reveals fundamental flaws or newly developed ones. Alternatively, it could be that the fund still has the same strengths and may rebound when the market changes.
And those who have been investing for a while know the market can turn on a dime. In years like 2000, 2003, 2008, and 2009, winners became losers and losers winners as the market violently lurched about.
We take a long-term approach, so a short-term slump doesn’t usually change our minds. That’s not always the case, however. In recent years, we’ve downgraded former favorites like Longleaf Partners LLPFX and Fairholme Fund FAIRX. In other cases, we are sticking with slumping managers.
There are many angles to each fund, but here are four things I am particularly interested in when looking at a slumping fund: Does the manager’s long-term record still look good versus the benchmark and peers? Has the manager changed her strategy? Has the manager dug in his heels on longtime favorites rather than keep an open mind about possible mistakes? Has the fund lost key managers or analysts who were important to past success?
To help you with your decision, I sorted funds by their three-year relative performance ranking to find the worst recent performers. All of those I’m highlighting are in the bottom decile for the past 10 years. I also limited my search to funds that were Morningstar Medalists two years ago and are still in the Morningstar FundInvestor 500.
Litman Gregory Masters International MSILX Ouch. This fund is up 3.4% annualized for the past three years, while the foreign large-blend Morningstar Category is ahead by about 400 basis points annualized and the category benchmark is ahead more than 500 basis points per year. The fund has five subadvisors charged with running a focused portfolio. We don't know exactly who hurt the fund, but the firm just fired Northern Cross in October, and Northern Cross' record at Harbor International HAINX was quite poor. In addition, the fund has David Herro of Oakmark International OAKIX, which has a poor one-year return and a middling three-year number. We like Oakmark and the team from Lazard, and the other subadvisors are solid, although we don't rate them. Focused funds like this one are particularly prone to slumps, so we still have a Morningstar Analyst Rating of Bronze on the fund. Since inception, the fund is still comfortably ahead of its category and benchmark.
Oakmark Select OAKLX Speaking of Oakmark, Bill Nygren is having a nasty slump. Again, you would expect that in a focused fund. But we did downgrade this fund to Silver while keeping Oakmark OAKMX at Gold. The fund's missteps in energy concern us. Energy isn't typically a big area of investment for the firm, yet it grew to 11% of assets and has been a real dead weight on performance. At year-end, the figure was down to 7%, however. Hence, the downgrade--but of course Silver means we still have a very high opinion of Nygren and team. (I still own it.) Nygren remains way ahead of peers and the benchmark since the fund's 1996 inception, and you may recall the fund rebounded from another nasty slump in 2007–08.
Sequoia SEQUX This fund's three-year annualized return of 7.3% doesn't sound so bad until you realize it trails 99% of large-growth funds. It's been a humbling stretch for the once-resilient fund. Not only has performance been awful but the fund has also been hit with the retirement of the two managers most associated with it in recent years. A huge, mistaken investment in top holding Valeant Pharmaceuticals caused the fund to lose money and spurred longtime comanager Bob Goldfarb to retire in 2016. David Poppe swore off such aggressive bets, but the fund has continued to lag--though in less dramatic fashion. Now Poppe is set to retire at the end of 2018.
The Valeant mess led us to cut the fund to Bronze from Gold in 2016, and we are keeping the fund at Bronze even with Poppe’s retirement. We think the process and the team left behind are still strong, even if some of the luster is gone. Sadly, the fund now lags the benchmark and peers going back to Poppe’s start date in 2006.
ClearBridge Aggressive Growth SHRAX This fund is an outlier in a couple of ways, so it's not a surprise that it would have slumps. It's a growth fund with turnover lower than an index fund. Manager Richie Freeman has been on the fund since 1983, and some of his favorite stocks have been in the portfolio almost that long. Comcast CMCSA dates back to 1986, and UnitedHealth Group UNH goes back to 1993. Freeman added one name to the portfolio in 2018: Ultragenyx Pharmaceutical RARE.
Inevitably, a fund like this spurs the question: Is it really doing anything? Yet, no one seems to mind Warren Buffett’s low turnover. To be sure, Berkshire Hathaway’s BRK.A return has more than doubled this fund’s return since 1990, but the fund is well ahead of the Russell 1000 Growth, so there are worse things one could do than hold this fund.
We have maintained our Silver rating here.
Harbor International HAINX Speaking of low turnover, Harbor has historically been very patient with the subadvisors of its funds. Yet it recently fired subadvisor Northern Cross for an extended bout of underperformance and a perceived departure from the firm's long-held strategy.
Harbor moved the fund to Marathon Asset Management in August. Although Marathon isn’t well known to individual investors in the United States, it is a big U.K. firm that runs a sleeve of Vanguard Global Equity VHGEX. Marathon is a little like American Funds in that it divvies up a portfolio among managers who build their own portfolios; in this case, the fund has nine managers.
We have confidence in Marathon and have taken the fund down just one notch to Bronze from its most-recent Silver.
First Eagle Fund of America FEAFX This is another fund laid low by Valeant, among others. That investment was a mistake, but we like Iridian Asset Management's focus on corporate change, such as management changes and mergers. Management estimates a private-market value for companies based on free cash flow and quality of management. And it looks for a catalyst to put the company on the right track.
Going back to Harold Levy’s start date in 1987, the fund is even with its benchmark and ahead of peers by a comfortable margin. The fund tends to hold up well in down markets, so it may simply be at a low ebb in the current bull market. We are holding its Bronze rating.
Hennessy Focus HFCSX We lack conviction in this fund and downgraded it to Neutral in December 2016. That was before the fund's slump hit in 2017 and 2018. Our reason for the downgrade was that fees had been ticking up at a time when the rest of the fund world was cutting fees. Given the managers' modest track record, we couldn't talk ourselves into a fund with fees that had risen to the highest quintile in its peer group.
Last year, cyclical holdings like cabinet maker American Woodmark AMWD and Camping World Holdings CWH poleaxed returns to the tune of a 10.4% loss.
RiverPark/Wedgewood RWGFX This is a focused fund whose emphasis on quality has had some nice winners but has been hurt by cyclical bets and more recently Facebook's FB many issues. We lowered it to Neutral in January 2018 because of concerns about execution. The fund has had bad timing, and it has lagged its separately managed account by more than 1.5 percentage points. Besides Facebook, Schlumberger SLB and Charles Schwab SCHW have nicked returns. In addition, we downgraded the parent company because of signs of stress such as fund liquidations.
AMG Managers Montag & Caldwell Growth MCGFX Our enthusiasm for this fund has waned. The fund started at Gold and gradually fell all the way to Neutral by July 2018. The fund had a changing of the guard as comanager Andrew Jung became the lead manager in January 2019 and longtime lead manager Ron Canakaris stepped back to be comanager.
More concerning than the transition, though, is that fees have risen significantly because of outflows. The fund’s prospectus net expense ratio has risen to 1.18% from a low of 1.03% in 2014. Outflows also led to a sizable capital gains payout in 2018.
Final Thoughts It's no accident that focused funds feature so prominently on this list. In order to make use of such funds, you really need to know the fund well and understand its role in your portfolio. It might help to make focused funds more-modest positions in your portfolio so that you can more easily withstand the pain.
A slump isn’t reason enough to fire a fund, but it is a call to dig into the problems and re-evaluate. You may find more issues than you'd expect. These funds show that, even when a fund seems to be the same old holding at first glance, there may well be changes bubbling beneath the surface.