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Notable Ratings Changes for Three Funds

Russel Kinnel
Christine Benz

Christine Benz: Hi, I'm Christine Benz for Morningstar analysts are frequently revisiting their ratings for various funds. Joining me to discuss three recent ratings changes is Russ Kinnel. He is director of manager research for Morningstar.

Russ, thank you so much for being here.

Russ Kinnel: You're welcome.

Benz: In Morningstar FundInvestor, which you are editor of, you regularly discuss some of the notable rating changes. So I want to talk about three recent ones--one upgrade and two downgrades. So, let's start with the good story. This is Fidelity Extended Market Index, received an upgrade from Silver to Gold. Obviously, a broad index fund, but let's talk about what the reason was for the ratings change.

Kinnel: That's right. Well, the Extended Market is a fund that essentially indexes everything that is not in the S&P 500, so it gives you broad small- and mid-cap exposure. And in this fund's case, its expenses are actually cheaper than Vanguard Extended Market, just slightly but a little cheaper. So, if you can invest over $10,000, it's 7 basis points, Vanguard is 9. If you under $10,000, it's 10 basis points whereas Vanguard is 22. So, it's a nice, very low cost way to get broad exposure to the small and mid-cap area.

Benz: I want to talk about Fidelity's prowess in indexing in generally. As you mentioned, the costs are very competitive. But I think this is maybe sort of an underdiscussed story that Fidelity is quite a good indexer despite its prominent actively managed funds.

Kinnel: That's right. You wouldn't think that there could be such a thing as under-the-radar news with someone as big as Fidelity. But they've lowered fees on a lot of index funds, and there are some very attractive options in there. I think obviously it partly reflects the growing importance of index funds for 401(k)s. Fidelity does not want to be left out, and they have got some very low-cost index funds, generally nice broad index funds that can really be at the core of your portfolio.

Benz: And they have the Freedom series of just index products.

Kinnel: That's right. They have also got target-date funds that combine index funds and some other fund of funds that combine index funds, and they are worth a look too.

Benz: So, Extended Market, you mentioned, is kind of a completer index. If you have S&P 500, you'd own it in tandem with that index fund, but you wouldn't want to own it in addition to, say, a Total Market Index Fund because you'd have a pretty significant overlap there.

Kinnel: That's right. It would be pretty redundant because you'd be indexing small and mid caps in both places.

Benz: So doubling up on them. OK. Let's talk about a couple of the funds that have recently received downgrades, and these are funds that you will talk about in the upcoming issue of FundInvestor. Touchstone Sands Capital Institutional Growth--a couple of things prompted the downgrade. We've still got it as a medalist, so it earns a Bronze rating, but it's stepped down from Silver to Bronze. Let's talk about the factors that influenced that downgrade of that large growth fund.

Kinnel: That's right. As you say, we still like it. They do a good job executing a focused large-growth strategy which is one of the trickiest things to do out there. And so, we did take note of the fact that Thomas Ricketts has retired, one of the comanagers on the fund. So that's definitely a concern, and I think especially at a focused fund, which as I mentioned it's a tricky thing to do. It's also tricky for individual investors to own those kind of funds because they can really be feast or famine. This is a fund, this year in 2016 it's having a tough year. If you look back, you can see there's other years that's been great. But when you have a concentrated portfolio of names like Netflix and Facebook, it's just going to be really volatile.

Benz: And in the analyst report there was also a note about size being somewhat of a factor, perhaps not as big a factor as in the past. But let's talk about how investors should think about size as influencing a fund's performance potentially going forward.

Kinnel: That's right. Size generally does have an impact on the fund's performance. Generally, it's not a big impact. So you can't really say the fund had a good year or a bad year because it was so big. But it can have an impact because as a fund gets bigger, it can mean it will have a bigger market impact as it trades stocks. It might mean that it has to own fewer small and mid caps and more into large. And it also might mean it has to be more diffuse. So maybe a fund that had 30 names now has 50 names. So there are a number of subtle changes that size can have on a fund, most of them are negative; one's good, sometimes it means lower fees. But it is something to watch out for, especially in small and mid caps but also in focused portfolios in general.

Benz: So, this fund being a more concentrated fund that we actually would think about size, even though it's large cap?

Kinnel: That's right. And it's a fund where that doesn't represent all the money in the strategy. They have got another similar fund; they've got separate accounts. So, it's also worth keeping that in mind as well.

Benz: So the big ratings change that I want to talk about today is Fairholme Fund where its rating was at Silver, has come down to Neutral, and it sounds as though issues or concerns about liquidity have driven that ratings change. Let's dive into that a little more.

Kinnel: Yeah. So the story with Fairholme Fund is it's a focused portfolio that has had some great years, but lately it's had some poor years, and that's led to some huge redemptions in the fund, and we're a little worried that the fund is painting itself into a corner. And what I mean by that is, in order to meet those redemptions Bruce Berkowitz has been selling off most of the really liquid equity holdings. So we're worried that at some point that might lead him to bump up against a very illiquid portfolio.

He has still got 23% in cash. He has got some more bonds that are liquid. So, it's not up for crisis today. But if you look at the redemption rate, you could certainly see where, say next year, maybe that does become a problem. Because when you look at the equity portfolio what you see is a very focused portfolio of not very liquid stocks. You see 14% in St. Joe's, 11% in Fannie Mae, 10% in Sears. You can't just get out of those positions very quickly. So, that's our concern. It's not so much where the fund is today but where it might be in a year or two.

Benz: So, investors who have hung on this long, they've been through a lot. They perhaps have seen some very good performance in certain years, but maybe some poor results in other years. What's your counsel to them? It's not negative. So we're not saying run for the hills. But what do we say to investors who are hanging on to the fund at this point?

Kinnel: Right. Well, obviously, Bruce Berkowitz is still a very skilled investor. So, it's not that we're saying that he no longer has talent or we were mistaken about that. I think it's more that we're saying--there are some heightened risks here around the redemptions and liquidity and now you're getting a pretty high-risk portfolio. It's a portfolio that over time has really changed a fair amount. Sometimes it's lower risk, sometimes it's higher risk. Looks pretty high risk when you look at those top names even with the cash holdings. So, I think you want to be wary of what's going on. I think you want to watch it closely. You don't have to necessarily sell. But does the fund still fit your objectives? Think about those things and also, if you are going to hold on, at least watch that cash position for any signs of added stress.

Benz: Last question for you Russ is, when you look at a fund like this, a very high-profile situation. Berkowitz was our Manager of the Decade last decade. What sort of postmortem do you and the team do on a situation like this? Obviously, it's really the portfolio that has changed more than your thesis on the fund. But let's talk about what sort of soul-searching you might do after an experience like Fairholme has had.

Kinnel: I think definitely it leads you to want to understand funds, how do they work. But I think one of the things this points out is that even a fund with a 10-year track record, it might still have some surprises for you. I think Berkowitz has done some things that maybe we didn't expect or others expected in terms of going much higher risk, having much higher-risk stocks as well, not just the overall portfolio but the individual stocks, whereas in the past it often had more stable companies that didn't seem so high-risk. So, I think that's part of it.

And I think also the impact of flows. Flows have been a really negative story for this fund, both inflows when it made the fund too big, but also by getting hot money it meant the fund had huge outflows in a couple of periods because that money that rushes in also rushes out. And now we're seeing another impact of flows. So, the mix of flows and concentrated strategies I think is really potent one that you have to watch closely.

Benz: OK. Russ, always great to hear your insights. Thank you so much for being here.

Kinnel: You're welcome.

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