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3 Funds That Mind the Downside

Christine Benz
Russel Kinnel

Christine Benz: Hi, I'm Christine Benz for We're more than five years into the current bull market, so it's probably a good time to look at how funds would behave on the downside. Joining me to discuss that topic and to share some low-risk picks is Russ Kinnel. He is director of manager research for Morningstar.

Russ, thank you so much for being here.

Russ Kinnel: Good to be here.

Benz: Russ, you recently wrote a cover story for Morningstar FundInvestor in which you looked at a statistic called downside capture. Before we get into that, I'd like to get your take on why it's a good time to be thinking about the volatility that might come along with certain mutual funds that you might be considering?

Kinnel: Well, as you said, we've had a great five-year run in U.S. equity markets. Usually, bull markets don't last that much longer. So, the longer you have a rally, the greater the chances that you'll then have a correction--not that I have a crystal ball telling me it's next week or even two years from now. But I think the further you get along in a bull market, the more it makes sense just to think about caution and also to look at performance through that lens because, of course, the most aggressive funds tend to best in rallies. So, it's good to keep in mind as you look at the performance of the last five years that it's really been slanted in the favor of those more aggressive funds.

Benz: So, some lower-risk funds really may not look that great when you look at their five-year returns, if you're looking at returns only. But you say to dig in and look at some statistics regarding risk. The specific one that you point to is downside capture ratio. Let's discuss what that is and how we calculate it.

Kinnel: So, downside capture ratio is referring to capturing the downside of a broad market index--the S&P 500, MSCI EAFE, Barclays U.S. Aggregate Bond Index. So, it specifically just homes in on when the market has gone down. For instance, if the S&P has gone down 10% and a fund loses 15% over that period, you'd have a downside capture of 150%. So, what percentage of the downside did that fund capture? Less than 100% is a good thing; more than 100% means it's doing worse than the market in down periods.

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Benz: So, in contrast to Morningstar Risk, which is calculated on a category-by-category basis, this one, as you said, is calculated based on a fund's performance relative to one of those broad benchmarks.

Kinnel: That's right. It's relative to the broad benchmark. It's also different from Morningstar Risk in that Morningstar Risk looks at volatility in both directions, whereas downside [capture ratio] obviously is only looking at the downside.

Benz: One thing you noted in your article was that if your particular fund doesn't have a lot in common with the broad benchmark, then maybe it's not going to be that useful of a statistic.

Kinnel: That's right. That's why I tried to focus on funds in categories that were close to the benchmark, so large-cap U.S. But you're right. If you're looking at, say, small value or if you're looking at, say, a high-yield fund versus Barclays Aggregate, then it's of less value.

Benz: So, you looked at a few major asset classes, looking for funds that had good downside capture ratios. Let's take a look at some of the U.S. equity funds that you highlighted. One of them is American Century Equity Income (TWEIX). It's been around a long time. Let's talk about its strategy and why it has historically performed pretty well when the market has not performed well.

Kinnel: Phil Davidson is a pretty cautious value investor with a long track record, and you can see that the fund has consistently lost less in downturns because of that strategy. Not only is the fund looking for stocks that pay out good income, which tends to be defensive in nature, but also it will go into convertible bonds, bonds, cash. That whole mix is really going to give you less risk than the overall market.

Benz: And that fund has a medalist rating of what, currently?

Kinnel: It's a Silver.

Benz: Moving on, let's take a look at another lower-risk fund. Yacktman Focused (YAFFX) is another one that you highlighted in your article.

Kinnel: Yacktman Focused is fairly different from American Century Equity Income in that, obviously, it's a focused equity portfolio. It's not going into convertibles or bonds, but it will build cash from time to time. So, that makes it a little more conservative. But also, it's focused on value; it's focused on companies with moats, high-quality companies often. That gives it a fairly defensive profile. And you can really see, then, in the performance that in some really strong rally years like 2013 it's often going to lag. But if you look at its record in '08, you see why you might want to buy a fund like that.

Benz: The fund had a manager change recently. It's going through some succession-planning issues. Let's talk about what's been going on from that standpoint and why you would still have conviction in it despite the manager changes.

Kinnel: That's right. Don Yacktman has been stepping back at the Yacktman funds, and Stephen Yacktman has been elevated. He has been on the fund for quite a while. So, it's not like he is brand new to this. He actually owns quite a bit of the track record, according to the Yacktman folks. But now, he's lead. You don't see Don Yacktman's name there anymore. But it's been clear for a while that it was increasingly about Stephen Yacktman. So, it's really been a long-running transition, and he now already has a fair amount of experience under his belt.

Benz: And the process should remain pretty much the same?

Kinnel: Yeah, very much so. I think you won't really see any jarring shifts. Yacktman is very much, like his father, focused on good-quality companies trading at low prices.

Benz: And you mentioned that cash is part of its tool kit. How high is cash, currently? I'm just wondering how defensive they are feeling.

Kinnel: It's about 15%, which means that's a fair amount more cash than the typical fund in that category. On the other hand, it's obviously not going to make it bear-market-proof. If the market goes down, it's still going to lose money; but that cash will come in handy. And possibly Yacktman will be able to invest that in a downturn, which would improve the returns coming out of the downturn.

Benz: Let's look at Vanguard Dividend Growth (VDIGX). It's another fund that showed really well from the standpoint of this downside capture ratio statistic. It has a lot going for it. Let's talk about what you think is so valuable about the fund.

Kinnel: So, its downside capture ratio isn't quite as good as the other two, but it's a fund that's fully invested. So, from that standpoint, it's really impressive that it still has as good of a downside capture ratio as it does. It's subadvised by Wellington, and the strategy is to look for companies that can boost their dividends. So, it's not aiming for maximum dividends today but companies that can boost their dividends. And in order to find those companies, that means companies with clean balance sheets, because obviously you need to be able to raise that dividend. So, the combination of the two really seems to put [the fund] in a sweet spot for attractive companies with some downside protection. So, it has really worked nicely. It was obviously a great recipe for '08 because that year was very much a debt-driven panic. So, it might not be quite as well suited for the next downturn, but I still think it's got a lot of appeal.

Benz: So, taking risk has been really well rewarded over the past five years. You think it's actually a good time to look at funds that put an emphasis on risk control. Thank you so much for being here, Russ.

Kinnel: You're welcome.

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