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Don't Give Up on These Three Funds

Sticking to their quality and valuation knitting held these funds back in the 2013 rally, but also makes them worth hanging on to.

Christine Benz: Hi, I'm Christine Benz for

A strong stock market lifted many boats in 2013, but some funds didn't prosper as much as others. Joining me to discuss three funds with weak near-term performance that investors shouldn't give up on is Shannon Zimmerman, associate director of fund analysis with Morningstar.

Shannon, thank you so much for being here.

Shannon Zimmerman: Good to be with you.

Benz: Shannon, let's do a little bit of stage setting. You have brought a list of funds that did not perform especially well in 2013. They had weak performance for a variety of reasons, but let's discuss some commonalities. What types of funds tended not to do especially well last year?

Zimmerman: If you look at the kinds of funds that did well last year, … it was a risk-on year, so to speak. Risk attributes, like a higher debt-to-capital ratio, for instance, for the fund's portfolio that was a plus.

Benz: So more leveraged companies?

Zimmerman: Exactly right. 2009 really isn't a typical year in any context, but it did raise into relief some qualities that were on view in a smaller way in 2013. Companies that were more speculative, had riskier profiles, not only in terms of financial attributes, but just in terms of volatility, higher beta companies, performed better.

These funds, the commonality, which partly explains why they didn't do well, was that that's not the kind of company they invest in. There's a quality bias across all of them to varying degrees.

Benz: We just want to be clear before we get into these funds with weak near-term performance that we're talking relative performance. Their absolute returns have been quite strong.

Zimmerman: Exactly right--all of them above 30% on the year. So remarkable returns in terms of absolute gains. But right--in relative terms, not so much.

Benz: Let's get right into this list. At the top is Wasatch Core Growth. This is a fund that had had actually quite good returns leading up until 2013, but very poor relative returns in 2013. Let's talk about what the problem was with this fund last year, apart from the fact that maybe it emphasized quality a little more than some of its peers?

Zimmerman: It's a concentrated fund. They are exclusively bottom-up managers, and they go wherever they find the qualities that they look for. The quality bias, as with all the funds as we were saying, definitely held this fund back.

There is a higher percentage of assets at this fund that are invested in companies that have economic moats, according to Morningstar equity research, lower debt-to-capital ratios by far. But that concentration, that willingness to back up the truck, almost by accident--because they're certainly not in a top-down way saying, I want this level of exposure to this particular sector--but they go where they find prospects that they like. So, even in a good year for the fund, it can look dramatically unlike the competition, because of the way that the sector exposures skew the performance of the fund.

Benz: So, you think the fundamentals here are still quite good despite this recent hiccup in relative performance. Let's talk about what you think are strong long-term attributes for this fund.

Zimmerman: To begin with, the management team. It's a two-person management team. They've been working together as a duo for about six years, but the senior manager on the fund has been there for over a decade, and both managers have actually been with Wasatch for over a decade.

They're well steeped in that investment process, which has served the shop and its investors quite well, and it has consistently over time been a process that has guided the managers toward quality companies, lower-volatility companies as well. There's a really good track record that's been academically vetted for that kind of profile of a firm, for the share prices doing dramatically better than riskier stocks over the long haul.

But because quality doesn't always win and because the fund does have lopsided sector exposure sometimes, investors at this fund, and in all of them [mentioned today], need to be patient and live through some bumps along the way. 2013 was a bump, but the long-term track record here is phenomenal. Over the [15]-year period, the fund ranks in the 6th percentile of the small-growth category, and it's a Silver-rated fund for us as well.


Benz: How about Wasatch from a parent or stewardship perspective? How does it stack up?

Zimmerman: Well, expenses are reasonable. At this fund, they're average, 1.21% …, relative to comparable peers, it's an average price tag. I always think funds could be cheaper, but that's a reasonable price tag anyway.

Benz: Let's segue into the next one. This is from another firm that tends to specialize in smaller-cap stocks, Royce Pennsylvania Mutual. The performance wasn't just bad in 2013, but it's actually had an extended streak of weak relative returns. What has contributed to that level of underperformance in relative terms?

Zimmerman: This fund has a massive portfolio of slightly more than 500 names. In a market environment like 2013, when there is a strong rally, a fund with that many positions probably isn't going to be at the front of the pack, so that held it back.

If you look at the three-year performance attribution data, though, it's somewhat surprising. Royce is a storied shop in some ways, and this fund is now in the small-growth category, and Royce is mostly storied as a value shop, and they are a value shop, it's just that they're looking at value in absolute terms.

But it's somewhat surprising to me to look at the performance attribution data and see that they have lost ground, relative to the index and the typical peer, not in terms of sector allocation because that's not something that's really important to them, but in terms of stock selection, which has been their bread and butter over the course of many years. Chuck Royce, who leads this fund, has been managing the fund since Richard Nixon was in the White House. He has been very successful over the long haul as a result of strong stock-picking, so recent years [have been] quite atypical.

Benz: I want to drill into this a little bit more. The fund is very large. I think anytime you see that and you're investing in some sort of small- and mid-cap fund, you have to wander, is that contributing to the underperformance. What do you think about that question?

Zimmerman: Well, it's a good question, and just because it doesn't seem to be affecting it, that doesn't mean that asset bloat isn't there. It's something that you can, in some ways, only see for sure after the fact. Royce has been pretty responsible about closing funds over time. I'm not sure about the track record [of closures] here, but Royce Special Equity has certainly closed when they thought that was getting too big, in a way that would impede results.

I do think that having 500 or more names in the portfolio helps to mitigate the risk that come with asset bloat, because you're spreading those assets across a very wide array of names. On the other hand--this isn't a very satisfying answer because I can't come down on one side or the other--they do have roughly 25% of assets in micro-cap names. So you have a big asset base, 25% of which is baked into micro-cap names. That's somewhat problematic, and it is big for a small-cap fund.

Benz: You also mentioned that the fund has had an emphasis on mining stocks. Let's talk about how that has been problematic for it.

Zimmerman: That shows up in the performance attribution in recent years, and it's not just this fund; that's been across the shop. Not every portfolio has had the same level of exposure, but certainly that's an area that has not served Royce well of late. They do have a three- to five-year outlook as they add new names to the portfolio. So maybe, the unloved of recent years becomes the loved of tomorrow, but that certainly has held the fund back over the last three years.

Benz: Shannon, you think on a forward-looking basis, though, the fund is still worth hanging on to.

Zimmerman: Absolutely. To begin with, for the same reason I think the Wasatch Fund is worth hanging on to. The manger has been, as I say, in place since 1972 running this fund. The shop has a consistent philosophy across … the style spectrum of more value-oriented portfolios and more growth-oriented portfolios, as is the case with this fund.

But because the long-term track record is so strong, because … the fee-level rating here is low. So quite cheap. The process has stayed consistent over time, too. It is fundamentally focused. The quality bias that was very dramatically evident with the Wasatch Fund--because it's a more concentrated fund--you can see that here as well. That's a part of Royce's process and always has been.

So when you consider that there has been a stylistic headwind based on the strategy, and when you consider that there are this many names in this portfolio during a year when it probably paid to be more concentrated, those things help me to understand and feel more comfortable with the recent performance, and certainly the long-term track record helps me to feel quite comfortable with the fund's prospects going forward, provided Royce stays in place and the strategy doesn't change.

Benz: Another fund that hit your list of funds with weak near-term relative performance that you think investors should hang to, or maybe even consider adding to, is FPA Perennial. That name may not be as familiar as the preceding two. Let's talk about what has hurt it recently and why you think its fundamentals are strong on a going-forward basis?

Zimmerman: In addition to the quality bias that we've talked about in connection with both of the other funds, this one has had a sizable cash stake. The managers … don't like to have more than 10% of the portfolio on the sidelines, and they are very valuation conscious, and they are very quality biased as well. So, given that we're in a year five of a market rally, managers who are as valuation conscious as these guys are, are having a hard time finding the kinds of companies that they like at a price that they're willing to pay.

Then, when you have a quality bias as well--cheap and high-quality--given how far the market has come in recent years, it's almost an impossible combination. So cash has gone beyond 10% at this fund; it's up to 12% last time I checked, and that's been a drag, obviously. If you have a market that's up as dramatically as the market was in 2013, you've got a big chunk of your change sitting on the sidelines. That's a sizable weight on the fund returns.

Benz: If people have problem funds like these or think they're problem funds, you think it's worth doing some due diligence, checking up on the fundamentals, before you decide whether to sell?

Zimmerman: Absolutely. During a period when it's very difficult to find unloved, maybe these are the unloved.

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

Zimmerman: Good to be with you.

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.