MUTUAL FUND SHAKEUPS! Transcript 11/15/2013 #1021

November 20, 2013

CONSUELO MACK:  This week on WealthTrack: Big shakeups in the mutual fund industry. Two veteran Morningstar analysts Christine Benz and Russ Kinnel discuss the massive outflows from bond funds into other investments and from actively managed funds into passive ones. What do these shifts mean for portfolio returns? Morningstar’s dynamic duo is next on Consuelo Mack WealthTrack.


Hello and welcome to this edition of WealthTrack, I’m Consuelo Mack.  There are mighty forces shaking up the mutual fund industry. The question is: are they temporary or are they revolutionary and depending on the answer how are they transforming the way we invest? No headline captured the changes more perfectly than the recent dethroning of PIMCO’s Total Return Fund as the world’s largest mutual fund, a position it has held since 2008, and its replacement by the Vanguard Total Stock Market Index Fund. Bond king Bill Gross, has become an investment legend largely because of his outstanding management of PIMCO’s flagship Total Return Fund which has beaten most of its bond competition over the years and has even delivered stock market like returns in various periods. The ascendance of Vanguard’s Total Stock Market Index Fund to the largest-fund throne symbolizes a new world order on two fronts.

Investors are now fleeing bonds after their nearly 30-year bull market and moving into stocks, which are now in the fifth year of a bull market. And perhaps even more earthshaking they are deserting actively managed funds in favor of mostly lower cost passive index funds.  Vanguard of course is where index funds were created by its founder, John Bogle, in the early 1970’s. The Vanguard Total Stock Market Index Fund is a low cost way to mimic the performance of the entire U.S. stock market.


This week’s WealthTrack guests have been following the mutual fund industry to the benefit of investors for two decades. They are Morningstar veterans who are making their first joint television appearance with us. Christine Benz is the Director of Personal Finance and Senior Columnist for the firm, where she has held many other prominent positions in her 20-year tenure there including Director of Mutual Fund Analysis and Editor of several of its newsletters. She is also the author of 30-Minute Money Solutions: A Step-By-Step Guide to Managing Your Finances, which is a WealthTrack bookshelf pick.


Russel Kinnel is Director of Mutual Fund Research and Editor of “Morningstar FundInvestor”, a monthly print newsletter for individual investors. He also oversees Morningstar’s fund analyst ratings, writes the “Fund Spy” column and a monthly mutual funds column for Kiplinger’s Personal Finance magazine. I began the interview by asking them to name the biggest unintended consequences of the huge shift from actively managed to passive funds.


CHRISTINE BENZ: As we’ve seen flows come out of active funds into passive products, what that has necessitated is that some fund  managers are having to sell stuff to meet the shareholder redemptions, and that can cause them to have to realize capital gains to sell securities that they might otherwise want to hang onto, and so what we’re kind of bracing ourselves for, because we have had a five-year equity market rally as well is that we could see funds making bigger than average distributions this year because (a) they’re meeting these redemptions and, (b), because they simply have big capital gains on their books.


CONSUELO MACK: So what does that do, Russ, to the funds’ performance themselves if they are basically being forced to maybe sell securities that they didn’t necessarily want to sell and make their portfolio smaller? What’s the impact on their performance?


RUSSEL KINNEL: Yeah, if you get redemptions to a critical level, say, 20, 30, 40% of assets, it can have a negative effect where the manager has to sell and maybe have to sell at lower prices than they want. That hurts performance. People redeem more, and so you have this negative cycle. Now, there’s a positive side if maybe redemptions are a little lighter or maybe flows are very mild. It can mean the fund still has enough flexibility to invest well. Usually five years into a bull market, lots of funds are overloaded with assets. This time there are still some good active funds out there that people have still overlooked five years in, and that’s a good part of it.


CONSUELO MACK:  Do you have a couple that you might want to mention to us?


RUSSEL KINNEL: Sure, so I think there’s some forgotten funds; funds that we knew once and have kind of lost interest in, so for instance, Longleaf Partners is a very good, old-school, deep- value focused strategy.


CONSUELO MACK: Was that closed at one point?


RUSSEL KINNEL: It has been closed.


CONSUELO MACK: Right. It’s open now? Longleaf?


RUSSEL KINNEL: It’s open. They have a small cap fund that’s closed, but the Longleaf Partners Fund is open, and they’re very careful about not taking in too much money or not taking money when the market looks overheated. So they’re just a really good, old-school active manager.


CONSUELO MACK: Should I be looking more closely at my portfolio and saying, you know, where am I going to get hit by these capital gains?


CHRISTINE BENZ: I think you should, and the nice thing is, is that most fund companies will print preliminary lists of distributions, so  you want to be on your guard, especially if you had maybe planned to lighten up on something anyway. It’s probably a good reason to get in there and do your selling before the fund makes its distribution rather than wait until afterwards, but I usually say don’t try to get too fancy in terms of timing these distributions. If you did not want to sell something in the first place, a capital gains distribution, provided it’s, say, under 10% of the net asset value, shouldn’t be an impetus to preemptively sell.


 CONSUELO MACK: All right, so where do you two come out in this active versus passive debate?


RUSSEL KINNEL: One thing active managers really can do better than most passive is they can moderate risk. We always think about performance, but an active manager can go into more stable stocks. They can build cash. They can maybe even have some shorts, but there’s a lot of good things that, if you look at it on the risk-adjusted side, active managers can add a lot of value, so I think more so than an asset class, I think about lowering risk, but there are asset classes. For instance, muni bonds is one where indexing doesn’t really work, and there are some really good muni managers. Vanguard’s funds are only slightly active, but they are active. Fidelity is a great muni manager as well. We really like their funds.


CONSUELO MACK:  So you don’t want to just have an index fund of muni bonds. You want to have somebody selecting them.


RUSSEL KINNEL: That’s right. You don’t want all of those credit risks just taken blindly.


CONSUELO MACK:  So Christine, are there better asset classes to be in active versus passive, for instance, and vice versa?


CHRISTINE BENZ: I think when we run the data on this issue, we tend to see it ebb and flow, and so at certain points in time, active management will look very good, other times less good. I really like your point about life stage, though, because I do think that for people who are retired and certainly in later retirement, the idea of using an indexed portfolio, very skinnied-down list of holdings I think can be really helpful. It gives the person less oversight. I talk to a lot of seniors who maybe are looking at a spouse who is not engaged in investing.  The all-index portfolio can enable them to have a very small list of holdings that the spouse could more readily come in and get his or her arms around if need be. So I do like indexing, particularly, for people who are maybe in their retirement years.


CONSUELO MACK:  Right. Let me ask you, too, about the fact that so many investors are fleeing bonds and bond funds, for instance. What are the potential pitfalls of that? What are the potential upside, you know, opportunities there?


RUSSEL KINNEL: Yeah, I think one of the risks is people are essentially trading interest rate risk for credit risk, so they’re going out of high-quality intermediate funds into higher-risk funds like high yield and bank loan, and those have lower credit quality, so you’re less vulnerable to a spike in interest rates. You’re much more vulnerable to a recession. Then on top of that, right now so many people have gone into it, but the yields aren’t really that good, so you’re not getting paid very well for that added credit risk.  So that’s a real concern I have. We’ve seen a really big shift in that direction lately.


CONSUELO MACK: So what do we do with our bond portfolios? I mean, how do we look at bonds now as an investment class?


CHRISTINE BENZ: I think we have to get back to that concept of matching your bond holdings to your holding period. When we hear about short and intermediate-term bonds, that actually means something. So if you are looking at short term, a short time horizon, you definitely do want to have cash and short-term bonds there, but if you have, say, a five or seven-year time horizon, I think actually you’re probably okay holding intermediate duration bonds.  The reason being is that you’re able to pick up a slightly higher yield, and then as yields go up, even though your principal will take a hit in the short term if you have a bond fund, you’re able to make some of that up with higher yields. So I think that basic concept of matching the duration of the bond portfolio with your time horizon is a good one at times like these.


CONSUELO MACK: That’s such reassuring, kind of simple advice. But I know one of the other things that you were concerned about, Christine, and I know you are, too, Russ, is that in this quest for yield is that people were going into riskier assets. So how dangerous are some of the alternative funds that people are going in to?  Russ, you mentioned bank loan funds, high-yield funds.  So how much danger is there in making that switch?


RUSSEL KINNEL: Well, if you go back to a year like ’08, you see the typical higher quality fund might have lost five percent.


CHRISTINE BENZ: Or even gained.


RUSSEL KINNEL:  Right. Some of them actually made money, particularly the ones that leaned heavily on treasuries, and then some of these high-yield and bank loan funds lost 20, 25, 30%, some even more. So it’s a big additional level of risk and, unfortunately, the timing is wrong. If you were doing this in ’09, that would be a pretty good time to have gotten in to them, but people have chased yield for so long that they’re just a lot less attractive than they were before.


CONSUELO MACK: So the search for income, where do we go? What do we do?


CHRISTINE BENZ: Well, I would also add that we’ve seen a great mania for dividend-paying stocks, and I think we would all agree dividend-paying stocks are great, but I think people have to be really careful not to supplant their fixed income portfolio for equities, even high-quality dividend-paying equities because the volatility profile of these two asset classes will be so different. So even in some sort of interest rate Armageddon, you are not likely to have equity like losses in a high-quality bond portfolio. So that’s one area where I’ve been a little concerned that investors are switching up one type of risk in favor of another.


CONSUELO MACK: Which brings me to another point, Russ, that you made earlier, and I know that you recently added a fund called the Westwood Income Opportunity Fund to your top 500 mutual funds, and that’s a conservative asset allocation, so you’re putting your asset allocation, it’s a balance fund, into someone else’s hands. Now, that is a big trend as well, these flexible funds that can kind of go anywhere and do anything. So is that a trend that we should be following as well?  Should we be looking into funds like that that are going to do the kind of asset allocation for you?


RUSSEL KINNEL: Yeah, now, this is a fund like a lot of the balance funds that do some of the allocation for you. They probably can’t do it all, though there are some. So I think they’re useful. I think tactical asset allocation, that’s the name for a lot of these funds, is valuable, and what you’re doing is you’re saying, “Here, fund manager. I want you to make these adjustments based on what’s attractive, et cetera.”  I think that’s good. We have to be realistic and understand no one’s going to make those calls right all the time.  So for instance, some of the funds that had been doing really well up until this year, this year a lot of the tactical funds have had a poor year because they were betting on emerging markets and they weren’t really in the right place. So I think they’re useful. I think a smart fund manager can probably do a better tactical job than most of us, but be realistic and don’t bet the ranch on these funds, because they are taking additional risks, making asset calls that you don’t want have it wreck your overall portfolio plan with a really extreme bet.

CONSUELO MACK:  Because one of the things that I’m also seeing more of are you mentioned unconstrained funds. So PIMCO has an unconstrained bond fund, for instance, and we just had Kathleen Gaffney on recently with the Eaton Vance Bond Fund. She had come, of course, from Loomis Sayles where she did a terrific job with Loomis Sayles Bond Fund, and this new thing is that I as a money manager, I want flexibility to go basically anywhere, and she’s investing in stocks now.  So what do you think about that kind of new class and the fact that more money is going into those kinds of funds as well?


CHRISTINE BENZ: We call them non-traditional bond funds, and we have seen an explosion of assets there. When we’ve looked at the funds, we see a real gradation in strategies. It’s kind of hard to categorize. You’ve got some very aggressively positioned funds, other funds that are playing it more conservatively. So we’re kind of watching, but I think to the extent that we would recommend any funds in those groups, we would really like the proven managers who have demonstrated that they can do well in a variety of these asset classes, so PIMCO for one we think does a good job across fixed income asset classes. Again, we would say that’s probably a riskier fund that investors should confine to the risky slot in their portfolios, but I think it really bears mentioning that you need to know the strategies and understand what you’re getting, because we’ve seen pretty broad gradations in the group.


RUSSEL KINNEL: The appeal of these unconstrained bond funds is that the manager can adjust durations so that possibly the fund might actually make money in a rising rate environment, but again, these are strategies where the manager has tremendous flexibility, so they might go the other way. They might have a lot of interest rate risk at the wrong time. So you hope they don’t, but you have to understand that it really has a lot of flexibility, and that means a wide range of potential results.


CONSUELO MACK:  Where do you two come out on the ETF versus the index, the mutual index fund?


RUSSEL KINNEL: I think really they’re fungible.




RUSSEL KINNEL: I think they do almost the exact same thing. For the long-term investor, an ETF or an open-end fund, you’re buying really a long-term, low-cost index. I think you want to include any commissions you might pay when you’re looking at your overall cost, but if it’s a total market ETF or open end fund, it’s really the same thing. Now, there’s also some ETFs that do wacky, crazy things, going after tiny little parts of the market that I wouldn’t touch, but if you’re looking at a comparable ETF or open end fund, it’s really just a matter of which is going to cost you less and generally they’re going to be pretty close.


CONSUELO MACK: But are you concerned about the behavioral aspects of this that is so… It’s easier, in fact, a little bit easier to basically trade an ETF than it is to trade an open end mutual fund.


CHRISTINE BENZ: I think that’s exactly the point, that if you are someone who really values that ability to trade intra-day as you can do with an ETF, ask yourself why you value that ability to trade intra-day, because when investors make some of these rapid-fire moves, often times they don’t get their timing right, and we see this again and again, and certainly this is the case when you look at some of the narrowly-focused vehicles where an ETF might focus on a single industry or a single country. We tend to see from our research not so much on ETFs but on open end funds that investors time those purchases very, very poorly.


CONSUELO MACK:  Christine, you actually wrote kind of a neat piece recently about target date funds and the fact that they’ve actually, through the last seven years, have proven their worth which really surprised me. So why have target date funds done well and how well have they done and why should we be paying a little bit more attention to them?


CHRISTINE BENZ: We’ve got a data point we call investor returns, and it attempts to marry cash flows in and out of a fund with the fund’s total returns. So if you were a buy-and-hold investor, you bought at the beginning of a time period, and you sold at the end, your return would exactly match the fund’s. What we see is that investors don’t do that. They zoom in and out, and often times they time their purchases poorly. When we look at target date funds, though, we see actually a beautiful pattern in that investors in target date funds actually out-earn the fund’s returns, because their timing is relatively good, and our hunch is that target date funds are big fixtures in 401(k) plans obviously, and so that dollar cost averaging, the fact that that money is moving into the funds for so many investors kind of on autopilot, that tends to give them a very good result, and the other benefit of target date funds is that they do constant rebalancing. So in late 2008, when everyone was feeling very pessimistic about the equity markets, if you owned a target date fund, your target date fund, behind-the-scenes, was actually buying stocks for you.  And so those two things together we think are responsible for delivering very good investor outcomes from target date funds.  I would call them a success.


CONSUELO MACK:  So Russ, let me ask you about the investor returns versus the investment returns in funds, because it’s an area that Morningstar has pioneered, and there is a huge difference. We call it the underperformance gap on WealthTrack, so tell me about the lessons from the investor returns that you’ve found.


RUSSEL KINNEL: That’s right. So the basic premise is that the typical investor usually makes about one percent less per year than the typical fund, and…


CONSUELO MACK:  Which adds up over time…


RUSSEL KINNEL:  …it adds up, and who knows how high returns will be in the future, so it’s a really big deal, and it tells us that people’s timing is not great, and when you drill down, you see some really interesting data which says higher-risk funds lead to much worse results, and lower-risk funds lead to much better results, and I think it’s just about human nature, that we do a lot better when we’re not really scared because we just saw really big losses in our fund. We’re not really greedy because our neighbor owns this fund that went up 100%. So really these boring funds, often balanced funds or anything that’s the lower-risk side of that category, people do better with those, because they feel comfortable steadily investing, and that’s where you really have good results, whereas the more extreme funds, even if they end up with a good long-term return, they might have such year-to-year extremes that people get out at the wrong time, and they get in at the wrong time.


CONSUELO MACK:  You two have been at Morningstar, each of you for 20 years, and over the years, looking at all the mutual funds, so give us three of your favorite funds for long-term investors.


CHRISTINE BENZ: Longleaf Partners, Russ mentioned them earlier, would top my list, something that I personally own.  Vanguard PrimeCap funds or some of the funds that PrimeCap manages under its own brand name.


CONSUELO MACK:  And those are actively managed, the PrimeCap funds.


CHRISTINE BENZ: They’re actively managed funds, and I think they’re absolutely terrific sort of contrarian growth managers. I own Vanguard PrimeCap Core.


CONSUELO MACK:  Growth managers, right.


CHRISTINE BENZ: They’re growth managers, but they’re sensible growth managers, and also managers who tend to be fairly easy to own relative to other maybe more volatile growth managers. I also like indexing, so while we’ve talked a lot about active products, I think if investors want to build a very low-maintenance, low-cost, tax-efficient portfolio, it’s really hard to go wrong with some sort of an all-index portfolio.


CONSUELO MACK:  And you didn’t mention bonds. You didn’t mention alternatives.


CHRISTINE BENZ: I didn’t, although I do think investors need bonds and need to be careful about supplanting even high-quality equities for bonds.  I didn’t mention alternatives because I tend not to love the category. I think we’ve seen a lot of these products come to market very overpriced and promising in many cases returns that’ll fall somewhere between stocks and bonds. If I’m maybe going to earn a six percent return and be charged two percent for the privilege, that just doesn’t seem like a great value proposition to me.


CONSUELO MACK:  So Russ, your favorites, at twenty years in, looking at all the mutual funds you follow?


RUSSEL KINNEL: One of my favorites is Dodge & Cox International. I really like everything they do, because a stock fund is something you want to own 10 or 20 years long, and therefore you want managers and analysts who are actually going to stick around. Dodge & Cox is one of those rare places. Christine mentioned PrimeCap. That’s another one where people tend to make a career. Managers and analysts stay there just about the whole time and generally only see them leave for retirement, and so they’re really committed to investors. The funds are low cost. I mentioned International because I think European equities are about as close to a bargain as you can find today in the funds, about two thirds in Europe. So that’s one of my favorite, but I think it also just really represents what you want in a good active manager, stable firm with a really good strategy.


CONSUELO MACK:  And that’s your one investment for a long-term diversified portfolio, as a matter of fact, right, Dodge & Cox International?


RUSSEL KINNEL: Yes, that’s my favorite. I also like Fidelity Tax Free Bond to give you a bond fund. Fidelity’s a very good muni manager. They don’t take big calls, so they’re not like PIMCO. They’re not making big bets on where the economy’s going. They’re just trying to pick the right issues and, over time, that does the job, too.  Another one I like is Royce Multi-Cap, Royce Special Multi-Cap run by Charlie Dreifus. It might throw you because it has less than a three-year track record, but Charlie Dreifus has a very long-term track record.


CONSUELO MACK:  Oh, he does.


RUSSEL KINNEL: This is just him taking his small cap approach into mid and large cap stocks, and it’s a very good one, and I like to find a fund where a small asset base and the manager can really make a lot with that flexibility.


CONSUELO MACK:  Oh, it’s so interesting. And what’s your one investment for long-term diversified portfolio, Christine?


CHRISTINE BENZ: Mine would be Vanguard Target, name your retirement year. I am very compelled by what we’ve seen from some of these target data products in terms of delivering good investor outcomes.  I would say for investors who want to be very hands off, that a good target product would be a great place to start.  So Vanguard’s target lineup is all index-based.  It’s about the lowest cost product that you’ll find, but we think the T. Rowe Price target date lineup is also very, very good. Those funds are active and a little more equity heavy; therefore, a little more volatile.


CONSUELO MACK: It is so great to have you two here. I feel like I’ve got an important part of the Morningstar brain trust here with us today on WealthTrack, so Christine Benz and Russel Kinnel, thank you so much for joining us on WealthTrack.


CHRISTINE BENZ: Thank you, Consuelo.


RUSSEL KINNEL: You’re welcome.

CONSUELO MACK:  At the close of every WealthTrack we try to give you one suggestion to help you build and protect your wealth over the long term.  This week’s Action Point is: put some of your investments on autopilot.


Christine Benz just mentioned how well investors in target-date funds have performed over the last seven years, one of the most tumultuous in market history, because of their disciplined approach. In their case they rebalance between stocks and bonds, buying when prices drop and selling when prices rise to keep their desired balance no matter what the market is doing. Taking the emotions out of the process, works. The old dollar cost averaging method of putting the same amount of money in the market or a favorite fund on a monthly basis is one of the simplest ways to start.


Next week we will sit down with one of Russ Kinnel’s favorite fund managers. Westwood Income Opportunity Fund’s Mark Freeman will join us to discuss where he is finding income. To see past shows, you can visit our website and check out our additional guest interviews and research in our Extra feature.  We also want to thank all of you who have reached out to us on Facebook and Twitter. We love knowing that you are having coffee or cocktails with us. Maybe both! Have a great weekend and make the week ahead a profitable and a productive one.

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