How to Find a Great Core Stock Fund
Tips on finding a large-cap anchor for your portfolio.
Fancy academic theories often express very simple ideas. For example, a part of academic finance called Modern Portfolio Theory divides up the stock market into style and market-cap segments (think of the Morningstar style box) and basically argues for diversifying or spreading your bets.
But spreading your bets doesn't mean diversifying equally among different funds. Some funds may deserve more of your assets than others. Morningstar analysts call the more important ones "core" funds and the less important ones "supporting" funds; we consider niche offerings like sector and regional funds to be "specialty," meaning you should relegate them to a small percentage of your portfolio. Premium users can see these designations (for funds that have analyst coverage) on the left-hand side of the fund Snapshot page, under the chart and trailing returns sections.
As my colleague Christine Benz recently discussed how to choose a core bond holding, this piece will highlight one type of fund--diversified large-cap funds--that can often serve as core stock holdings in a portfolio. In a follow-up piece, I'll discuss whether so-called "go-anywhere" funds can serve as core holdings.
Why Large Caps?
Typically a core stock holding is a large-cap fund. That's because the market is made up of mostly large-cap stocks. (A stock's market capitalization, or cap, is its number of shares outstanding multiplied by its price per share. Currently, anything over $10 billion or so in market cap is considered large cap.) In fact, large caps account for about 70% of both the DJ Wilshire 5000 Index and the Morningstar U.S. Market Index (two indexes that approximate the whole domestic stock market). This is primarily why advisors put the bulk of their clients' money in large-cap stocks or mutual funds and why Morningstar designates most funds that own large-cap stocks "core" holdings. You're simply getting exposure to a bigger slice of the market when you own a large-cap fund than when you own a mid-cap fund, small-cap fund, or a fund dedicated to a particular sector or industry of the economy.
Does this mean that you must always have 70% of your stock exposure in large caps? Not at all. Different allocations may be appropriate for different investors. However, it's important to know what the market looks like, if for no other reason than to understand how you might be deviating from it.
Given the recent strong performances of small and mid-caps, a question that naturally arises is 'why does my portfolio have to look like the market with all those lackluster large-caps?' And it's true that large, established companies are subject to the same problems as other kinds of companies. They can get overpriced, as we saw during the bubble years (2000-02), and they can engage in large-scale deception and fraud as we saw with Enron. But despite recent underperformance, large caps tend to be steadier over extended periods of time than smaller stocks, giving investors the courage to stick with them through the rough patches. In short, they tend to be solid businesses with steady profits that compound your money decently over time.
Also, as hard as it is to believe six years into a small-cap rally, there are times when large caps do better than the rest of the market. One common theme we heard two weeks ago at the Morningstar Investment Conference was that steadier, high-quality, large-cap businesses look as cheap now as they have in a long time and that a return of interest to businesses with steady earnings and profits might be in the offing after a period of investor neglect. If the economy slows, large-cap stocks tend to hold up better than their smaller counterparts for a variety of reasons. Multiple product lines (often with brand-name recognition), market dominance, multiple customers often spread around the world, greater access to capital, and generally stronger management teams are some of the reasons why larger businesses can withstand difficult economic times. We certainly don't advocate dumping all your small-cap funds, but now may be a particularly good time to recheck your allocation and make sure that your core holdings are beefed up enough.
If you've decided that you want to use a large-cap fund as a core holding, there are a few other factors to bear in mind. First, you should consider fees. Although it may not seem like a big difference whether you're paying 1% or 2% as an expense ratio, fees cut into returns dramatically over time. Additionally, even if the stock market continues to return the 10% or so annually that it has, on an average basis, returned over the past 75 years, keep in mind that inflation has run at over 3%, meaning that stocks have only increased your purchasing power by 6% or 7%. In other words, every percentage point counts when it comes to trying to beat inflation, and you should try to pick a fund for a core holding that has an expense ratio of around 1% or less.
Second, if you're picking an actively managed fund (instead of one that simply tracks an index like the S&P 500), look for an experienced manager with a solid track record. As in other professions, experience counts in the investment world, and you want to make sure that the manager has weathered market storms reasonably well and has stuck to his investment style when it was out of favor. Morningstar analyses tend to focus lots of attention on a fund's management team, and there's a management section beside every analysis giving you the dope on what we think of the manager and analyst staff at a particular fund.
Third, consider an index fund--especially one that follows the S&P 500 Index, the DJ Wilshire 5000 Index, or the Russell 1000 Index--as a core holding. Index funds are generally low-cost options that virtually guarantee to get you nearly all of the market's return. This doesn't make them safe in the sense of being good at preserving capital, because markets can decline dramatically from time to time. However, most actively managed funds have a hard time beating the major indexes, so an index fund can relieve you of the burden of searching for one that has in the past and that has a good chance to do so in the future; you also won't have to worry about changes in management or strategy.
Some of our favorite funds culled from our Analyst Picks Lists include:
Oakmark (OAKMX) and Oakmark Select (OAKLX)
Bill Nygren, who runs both of these funds, is a seasoned investor with a value bent. However, he's not afraid to roam where the values take him, and his funds often occupy the blend areas of the style box in addition to large-value and mid-value. Currently, he thinks large, slow-growing companies such as Wal-Mart (WMT), Dell (DELL), and Bristol-Myers Squibb (BMY) are good bargains. He thinks many such superior businesses are trading as cheaply as they have in recent memory and are unfairly valued similarly to inferior businesses. Nygren's funds have struggled recently, but he has not wavered in his style and his convictions, and we think this bodes well for the future of his funds.
Fidelity Dividend Growth (FDGFX)
Like Nygren, this fund's manager Charles Mangum has struggled recently, but we think he is an experienced stock-picker who will again have his day. His preference for solid companies with strong balance sheets has kept Dividend Growth out of favor recently, as lower-quality businesses have been the darlings. However, we derive some confidence from the fact that the fund traversed the recent decline in late May and early June well. We think it's worth betting that businesses such as AIG (AIG), Home Depot (HD), Wal-Mart, Johnson & Johnson (JNJ), and General Electric (GE) will return to favor. When they do, this fund will be poised to benefit. Its emphasis on the largest, high-quality companies makes it a fine core holding.
Fidelity Spartan 500 Index (FSMKX) and Vanguard 500 Index (VFINX)
These two funds track the S&P 500 Index, the index of the 500 largest companies by market cap. This index comprises roughly 70% of the capitalization of the domestic stock market. Although it's been easier for actively managed large-cap funds to beat these two stalwarts lately by dipping down into mid-cap land, we think these two index funds' low fees and trading costs will still make it difficult for most funds to overcome them over the longer haul. Fidelity's expense ratio is 0.10% versus 0.18% for Vanguard, but Fidelity requires a $10,000 minimum in taxable accounts. Either one of these would make an excellent core holding.
Fidelity Spartan Total Market Index (FSTMX) and Vanguard Total Stock Market Index (VTSMX)
These two funds track the Wilshire 5000 and MSCI U.S. Broad Market Index, respectively. They are supposed to be proxies for the entire domestic stock market, so investments in them would theoretically eliminate the need for mid-cap and small-cap supporting funds. For example, the Wilshire 5000 consists of not only the 500 largest companies, but also the next 4500 in market cap. Once again, the Fidelity option is cheaper than the Vanguard offering, but it also requires a hefty initial minimum of $15,000 in taxable accounts. These two are the most comprehensive core holdings. If you choose one of these, the only other things to consider are how much international and bond exposure you want.
In a follow-up article, I'll consider whether certain "go-anywhere" funds that don't limit themselves to large-cap stocks can be core holdings.
John Coumarianos has a position in the following securities mentioned above: JNJ. Find out about Morningstar’s editorial policies.