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Quarter Ends With a Whimper for Stock Funds

Christine Benz
Russel Kinnel

Christine Benz: Hi, I'm Christine Benz for Stock funds ended the quarter with a whimper, but many are still in positive territory for the year. Joining me to recap the quarter-to-date and year-to-date fund performance action is Russ Kinnel, he's director of manager research for Morningstar.

Russ, thank you so much for being here.

Russ Kinnel: Good to be here.

Benz: Russ, I want to talk about equity-fund performance during the third quarter. What are the key trends that you see when you look across our various equity-fund categories?

Kinnel: This was one of those quarters where [the Morningstar Style Box] really explained a lot. Small cap versus large: Large was much better than small. Small value was the worst. It really got hammered. Large growth actually had a slightly positive return. So, a really dramatic story around the style box this quarter.

Benz: Let's talk about why that was. Why have small-cap stocks been getting hit so hard? Not just during the quarter but really all year. It's not been a great year for small caps.

Kinnel: I think a big part of it is simply reversion to the mean and valuation--that small caps had gotten quite pricey, historically. Large caps, not so much. If you remember at our conference in June, Ben Inker of GMO actually said he wouldn't touch small caps with a 10-foot pole. So, there were clearly a lot of people who have been saying small caps are pricey and that seemed to have an effect on the market. Now, obviously, there are always a lot of other things going on; but I think some of that was just valuation and reversion to the mean.

Benz: And large caps were arguably more attractive coming into this year?

Kinnel: A little more attractively priced. They've lagged small caps for a number of years. So, I think they had a little room to catch up, and I think that's being reflected. I think you're seeing a little more growth there. Growth is still somewhat hard to come by in this sort of sluggish recovery, and a large growth with some of the big tech names and some of the health-care names is still delivering that.

Benz: That's what I wanted to ask about--the growth/value spectrum. When you look at that, do you see any pronounced trends?

Kinnel: For the year, it's not that dramatic; but for the quarter, we saw large growth beating large value and small value lagging small growth. So, definitely growth is doing better for a change.

Benz: Most equity funds, certainly large-cap funds, are in the black, year to date. Small-cap equity, not so much. This is domestic equity. Turning over to international equity, what sorts of trends do you see there? Do you see the small caps underperforming there and large caps doing relatively better?

Kinnel: Yes, but it's much more muted. So, everyone had a bad quarter in foreign funds last quarter, but not nearly as dramatically so. Maybe a 5% loss for a foreign small-cap fund versus a 3% or 4% loss for a foreign large cap. So, much more nuanced and, really, everyone had a bad quarter.

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Benz: Russ, another thing I wanted to cover with you is that a lot of people have been waiting for this resurgence in emerging-markets stocks. People thought they got very cheap. Have they, in fact, rebounded so far in 2014?

Kinnel: On relative terms, yes. Emerging markets, in general, have held up better. You're probably in the black in your emerging-markets fund, unlike your developed-markets foreign fund. India was the big story because it had gotten really crushed last year, and it has rallied really strongly--up about 35% for the whole year, about 5% for the quarter. But some of Asia's other emerging markets actually did pretty well, despite some other bad news in places like Thailand.

Benz: And you say that developed Europe was actually the worst place to be so far this year.

Kinnel: That's right. So, Europe really took it on the chin for a change. And if your foreign-equity fund was heavily in Europe, it probably underperformed its peers; if it was more tilted toward Asian emerging markets, it probably outperformed.

Benz: Russ, you brought a few individual fund names that you think illustrate some of the performance trends we've seen so far this year. Let's start with the first one, Dodge & Cox International Stock (DODFX): a big, widely held foreign large-cap value stock fund. What's going on there and why has its performance been so good so far in 2014?

Kinnel: It's up about 5%--thanks largely to health-care stocks, like Sanofi (SNY). It's just done really well. It's encouraging because it had a rough 2008, but it has really come back strong since then.

Benz: Then, another U.S. equity fund, PRIMECAP Odyssey Aggressive Growth (POAGX), you say is having a great year. What's driving the strong performance there? It's been quite a run for PRIMECAP generally.

Kinnel: PRIMECAP has been doing great. Biotech is a big part of that. And, oddly enough, some of the old-school tech that you might not have expected would do well--or you think wouldn't have done well since the '90s--BlackBerry (BBRY) and Micron Tech (MU) are two of their better-performing holdings this year. So, really, a good mix of health and tech. And tech is trickier in a smaller-cap realm; we saw a lot of tech names actually get hit, but PRIMECAP seems to mostly be getting the winners.

Benz: Over in the column of funds that have had a really difficult year: Conestoga Small Cap (CCASX), you say, illustrates some of the troubles that small-cap funds have had.

Kinnel: That's right. We like the two winning funds we mentioned, but we also like this one, unfortunately. Conestoga is down 16% this year, which is a pretty brutal loss considering most small-cap funds are down more like 6%. It's had a lot of niche tech companies that have taken it on the chin. We had talked about that search for growth. Some of these niche tech companies really aren't delivering and they've gotten hit hard; unfortunately, Conestoga is really bearing the brunt of that.

Benz: Another small-cap fund that we like that's also having a difficult year is Artisan Small Cap Value (ARTVX). What's going on there?

Kinnel: It's off about 10%. The story there, in part, has to do with energy; they've got some energy holdings. And as you know, energy stocks, in general, have not done well this year, and so that's really smacked the fund pretty good this year.

Benz: One question I have for you, Russ, is that a lot of funds that I would say have sort of a quality emphasis have not had a good run. Maybe they're doing a little better so far in 2014; but over the past five or six years, they just haven't distinguished themselves. What would you say has driven that underperformance there? And should investors have patience with those types of funds?

Kinnel: It's really tough because the defensive high-quality stuff, naturally, did really well in 2008. But it hasn't really done so well since then. And you are now looking at, for funds like Dreyfus Appreciation (DGAGX) and some funds that are pretty good funds--Jensen fund (JENSX)--that they have lagged for four or five years now and it really is trying people's patience.

I would say, for the most part, if you've got a good fund, it is probably [a good idea to] stick with it. Quality is something that does go in and out of favor. I think part of the problem is that, like I mentioned, while there are corners of the market delivering growth, the high-quality names have been a little bit disappointing. So, these funds have lagged; but again, I think it's not a bad idea to have some defensive holdings, especially since we've had a great rally. A little defense is a good thing.

Benz: Russ, it's always great to get your perspective. Thank you so much for being here.

Kinnel: You're welcome.

Benz: Thanks for watching. I'm Christine Benz for