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2013 Not a Gamechanger for Equity-Fund Investors

Small and mid-caps outperformed large, and growth was mostly better than value, but Morningstar's Shannon Zimmerman urges investors to stick with their game plans.

Christine Benz: Hi, I'm Christine Benz for Equity mutual funds enjoyed very strong returns in 2013. Joining me to provide a recap of the year is Shannon Zimmerman. He's associate director of fund analysis with Morningstar.

Shannon, thank you so much for being here.

Shannon Zimmerman: Good to be with you, Christine.

Benz: Shannon, this is the time of year, where investors do that review of their portfolios' holdings. Let's start with the Morningstar Style Box lens. When you look at the Morningstar Style Box, in which categories have outperformed and underperformed, what do you see? Am I better off in small versus large, value versus growth, and so forth?

Zimmerman: Yes. Certainly, this year, smaller has been better. Everybody is a winner in absolute terms; the market is up substantially year to date. But small-cap, on a relative basis, has certainly outperformed larger-cap fare. Mid-cap funds have done better than large-cap funds, as well.

The valuation spectrum has been less of a factor. But still, growth funds--at least at the extreme--in the small-cap arena, growth funds have outperformed value funds. And that's also true among large-cap funds. Large-cap growth funds have fared better than large-cap value funds.

And among mid-cap funds, the reverse is true. Value has actually beaten growth. But the valuation spectrum really has been a small factor compared with the market-cap factor which has been quite large.

Benz: I should keepthis in mind as I review my holdings. Even if I have, say, a large-blend fund that I know tends to lean a little bit toward growth stocks, that might explain why it has beaten its peers so far this year?

Zimmerman: That's exactly right. You might have a manager who got lucky and was standing in the right place at the right time.

Benz: When you look at the sector view, are there any sectors that have performed especially well, and which sectors would investors look to as being sort of depressive when they look at their portfolio holdings?

Zimmerman: Utilities have fared the worst among the sectors. But the two sectors that we've kind been talking about off and on throughout the year--consumer discretionary and health care--are the ones that are kind of going to go down to the wire.

Consumer discretionary as of [Dec. 15] is up on health care by less than a percentage point actually. They've been neck and neck all year, and it's going to go down to the wire.

Health care is particularly interesting because you might think that the companies that are doing best in the health-care sector are those that would benefit from the dust mostly settling on Obamacare. But that's not the case. It's really that the biotechs. Gilead Sciences is among the top performers in the health-care sector and so is Biogen Idec, which is up over 110% so far in the year.

Benz: Even if I don't own a sector fund, I probably still have a fund or two that have benefited from these types of exposures?

Zimmerman: Absolutely. It's such an important point. A lot of times, we'll field queries from reporters, and they want to know about the hot tech fund, for instance. And we'll say it could be the S&P 500 because if you invest in an S&P index tracker, 20% or more of your assets are already in tech. How much more do you need? That's true for health care, as well, this year.

One of the funds that I cover is ClearBridge Aggressive Growth, which is run one by the longest-tenured managers in the industry, Richie Freeman, and his comanager, Evan Bauman, who we had a chance to speak with about a month ago. They have about a little over one third of that funds' assets in health care right now. Biogen Idec is their top holding, and it's a huge position size, too, at about 11%. Lo and behold, the fund is doing quite well.

Benz: Pretty good.

Zimmerman: It's a very volatile fund, very concentrated in terms of overall names, but then concentrated at the very top of the portfolio, as well. But, yes, it is having a terrific year; in large part. Richie Freeman is a good stock-picker. But having one third of the assets in health care has certainly been a benefit.


Benz: When you look at active versus passive, this is a topic that investors are keenly attuned to. We've seen a lot of the flows going to the passively managed products. How have active funds done versus passive year to date?

Zimmerman: This is a good year by and large for active managers, not in the large-cap arena, which in some way stands to reason. The typical large-blend fund has lagged the S&P 500 trackers, or a total stock market tracker this year, which kind of makes sense. I'm always surprised when you have these sort of middle-of-the-road large-blend funds that do have a year of outperformance because obviously the large-cap arena is the most efficient part of the market. It's hard to buy household names like Johnson & Johnson well.

This year, at least relative to the S&P 500, the typical large-blend fund has lagged by a little less than 1 percentage point, and then versus a total stock market tracker a little more, I think, than 1 percentage point.

The story is little bit different among mid-cap and small-cap funds. Historically, the S&P MidCap 400 Index has been a very difficult bogey for active managers to beat. But this year they've beaten it by almost 3 percentage points. Then historically, the Russell 2000 has not been a very difficult benchmark to beat. And lo and behold, the typical small-blend fund has outperformed the Russell 2000 yet again in 2013.

Benz: Shannon, I'd like to home in on a few actively managed funds that are big constituents when you look at 401(k) plans. Let's talk about say, starting with Fidelity Contrafund, how it has done. Can you just give us a quick snapshot?

Zimmerman: Interestingly, Fidelity Contrafund does not have an outsized stake in health care, but it is one of the biggest fund owners of Biogen Idec, even though Contrafund is so huge now at over $108 billion [in assets]. It's a relatively small position in terms of the shares outstanding, but the company is quite big.

Contrafund isn't having a shoot-out-the-lights year, but it is having a strong year, an above-average year.

Interestingly, given that fund's track record, the manager--obviously, Will Danoff, quite a talented manager and has a fantastic long-term track record--and given that this year flows have been coming back in to domestic-equity funds, that fund has actually seen outflows every month this year, except for January, which I find somewhat surprising. People are tuning into how much it has in assets, and it's still open to new investors. Danoff has not closed it. He thinks he is not capacity-constrained even at $108 billion. It's having an above-average year but not a stellar one.

Benz: Shannon, let's take a look at American Funds Washington Mutual. How has that one performed year to date?

Zimmerman: Like Fidelity Contrafund, it's having an above-average year, but not a terrific year. It's in the 44th percentile through the end of last month. It's an interesting fund because in the past we've talked about whether or not there is a dividend bubble or bubble for dividend-paying stocks. This fund has a yield of about 2%.

It also has a quality bias, and quality companies often command higher premiums. And this is a large-value fund, but on every value measure, the fund is more expensive than its typical peer on a price/earnings, price/book, and price/cash flow basis. It's a pricey value fund, at least on a relative basis, but it's still doing quite well but just not a shoot-out-the-lights kind of year.

Benz: How about the Vanguard Wellington?

Zimmerman: Vanguard Wellington is actually having not a shoot-out-the-lights kind of year, but a better one. It is just outside the top quintile of its category. And that's an interesting fund, as well, because there is a bond sleeve, and they have historically been quite strong bond managers. But it's going to be interesting to see what the strongest bond managers in the industry are able to do if and when, and presumably it's "when" interest rates do finally spike and inflation finally does rear its ugly head. Historically those are horrible for bond investors. It's going to be interesting to see if the talented folks in the industry are able to dodge that bullet.

Benz: As people look upon their portfolios at year-end 2013, what kinds of changes should they think about making? What changes should they avoid making right now?

Zimmerman: The first thing to say, I think, is stick with your game plan. It's something that most investors have thought long and hard about. And if the thesis that informs that game plan when you first put it together still holds water, there is no reason to lurch toward something that you didn't already have in your portfolio or lurch out of anything.

Benz: And if you didn't have a game plan, get a game plan?

Zimmerman: That's exactly right. However, that said, given what we were talking about at the top of the segment, it may be the case that you are more allocated to small caps than you thought just because of market depreciation. The same might be true, if only slightly less dramatically, for the growth side of you portfolio, as well, because growth has outperformed this year and incrementally last year, as well.

Then your fixed-income exposure is an important consideration right now. I know we were just talking about Wellington and the talented bond mangers that they are, it's going to be tough, when inflation and interest rates do rise, for anybody who has invested in fixed income to dodge that bullet.

You might think about--and I know this is advice for retirees--but you might think about allocating new investment dollars, which might otherwise go to a fixed-income fund, to cash and be opportunistic once the fixed-income market finally rights itself.

The last thing I would say is it's always a good idea to buy the unloved as you rebalance--great funds that have been out-of-favor just because of their style. It's a smart strategy for long-term investors. But particularly right now when the market is fairly valued--according to some, even overvalued--it's an excellent opportunity if you're going to send your new investment dollars into the equity markets to find the funds that have been out-of-favor because it's a better way to find at least a relative value.

Benz: Your advice is: Have that strategic asset-allocation plan, stick to it, and then rebalance back to it if you are out of whack?

Zimmerman: Exactly.

Benz: Shannon, thank you so much for being here.

Zimmerman: Good to be with you, Christine.

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

Christine Benz does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.