Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Commodities have been at the epicenter of the current market sell-off. Joining me to discuss the implications for fundholders is Russ Kinnel--he is director of manager research for Morningstar as well as editor of Morningstar FundInvestor.
Russ, thank you so much for being here.
Russ Kinnel: Happy to be here.
Benz: Russ, in your latest issue of FundInvestor, you have a discussion of some of the categories that have been hardest hit by this sell-off that we've seen in various commodities, especially energy producers. Let's talk about the commodities funds and the energy-specific funds themselves.
For people who own these funds, what are some things they should be thinking about at this time? They have seen very big losses in their holdings, and I guess it's a natural question to wonder whether such a fund really deserves a spot in your portfolio?
Kinnel: I think it naturally raises those questions because we saw one of the great commodity and energy bull markets and now one of the all-time bear markets as oil keeps getting cheaper and cheaper. You see that reflected in how these energy funds, these commodity funds have taken huge losses.
I think there are a couple of lessons. I think one is that you want to be moderate in your allocation to these kinds of funds, especially commodities fund because commodities are more or less a zero-sum game. There is no reason that they have to go up, but they are a good diversifier. So, keep that position moderate. But I think, from another angle, maybe I wouldn't necessarily completely give up on them because we are at such an extreme low. It may well turn out to be that sometime in 2016 we hit the secular low for this bear market in commodities and energy. So, this might also be a buying opportunity. If you are thinking about the upside, certainly I think commodities and energy probably have as much upside as anything at this stage. But, of course, they also have tremendous downside. So, my message is maybe to think about having a small position in these kinds of names. In my own 401(k), I have maybe a 3% or 4% position in commodities.
Benz: I know when our colleagues at Morningstar Investment Management look at asset allocations, they typically recommend about 5% at the high end in commodities. I think a question, though, for investors is whether a lot of these commodities funds were launched at exactly the wrong time. We kind of saw this proliferation of them in the mid-2000s. Were the fund companies kind of driving with the rearview mirror in terms of deciding to come out with all these commodities-focused products?
Kinnel: I think the first wave actually caught a nice rally because the commodities didn't start crashing until '09 or '08, I guess. But the second wave really was poorly timed. There is certainly a very long history in the fund industry of products and category types being a negative indicator--that is, they typically aren't launched until a rally is long in the tooth. So, something you can apply to all areas is always be a little wary of any kind of hot, new product.
Benz: Another group of funds, broadly speaking, that have been affected by this commodities and energy downturn have been value-oriented funds that sometimes like to pounce on these companies that they think are perhaps temporarily depressed. That they have gone down and stayed down, I think, has been a surprising thing for many of these value-leaning funds.
Kinnel: That's right. It's not nearly as severe a sell-off as we saw in oil itself. But if you own a value fund, it's probably been hurt by energy. If your value fund really underperformed in 2015 and so far this year, it's probably because it's above market weight in materials and energy. So, again, it's worth keeping in mind that these things are cyclical. These funds might come back for those same reasons. I wouldn't want necessarily want all my value funds to have that bent, but it's not such a bad idea to have, say, one deep-value fund--especially if it's still got a good long-term track record. I think these kinds of names can be a nice contrarian bet.
Benz: Another category that has been quite affected by the downturn in basic materials and energy producers has been the emerging-markets group. Let's discuss the connection for people who may not be so familiar with why they tend to be vulnerable to these negative-price cycles and then discuss takeaways for emerging-markets fundholders.
Kinnel: There are two reasons that commodities have a huge tie to emerging markets. The first is that China is the biggest emerging market, and it's a massive consumer of commodities. And much of the bull market in commodities was built on the premise that China was growing at a tremendous rate and people expected them to continue to grow. More recently, as China has showed its rate of growth, that's had a huge impact on commodities.
Then, secondarily, a number of the big energy and other commodities-producing countries are emerging markets--Brazil, Russia, and so on. So, you have two strong links to China/commodities and, therefore, the slowing China growth has really hit emerging markets hard. But again, I think this is an area that maybe has a lot of potential because emerging markets have really underperformed the rest of the world in the last few years. That may mean they are starting to get cheap, and that may mean they are set up for a nice run--not that I have any idea of when the right time to buy is because I don't.
Benz: Investors often wrestle with whether to own that dedicated emerging-markets fund or own it as a part of a foreign-stock fund. Do you have a preference there?
Kinnel: Not really. I think, generally, it's probably a good idea to have a little of each just because if, say, you have a foreign fund that has some emerging markets and they sell those emerging markets, then maybe you lose your exposure even though you wanted to have some. So, in general, you probably want to do it in both ways. Most foreign funds have some emerging markets. So, I wouldn't be too much of a style purist and try to get one that has none. I think it probably makes sense to have a little of each.
Benz: Let's take a look at another group of funds. These are bond funds that have, perhaps to some investors' surprise, been quite vulnerable amid this commodity-price slide. Let's start with high-yield bonds, discuss the connection, and why several of them have actually skidded pretty hard with this commodity-price downturn.
Kinnel: That's right. High yield has had a pretty nice run for a number of years, but that really stopped last year, and we saw investors kind of give up on it as well. The reason is energy issuers represent about 10% of high yield, and then there are some other materials and other names that are another piece. Your typical high-yield fund will have significant energy exposure and, of course, some high-yield funds were overweight energy, which means they were really hit hard. That's almost a perfect explainer. If you see a high-yield fund that underperformed in 2015 and so far this year, you can bet it was overweight energy and materials.
Benz: So, is it similar, though, to the value-oriented stock funds? Are some of these high-yield managers, in fact, kind of value-oriented themselves and see opportunity there?
Kinnel: We really hear mixed things. Some particularly more cautious high-yield managers are saying, "I'm not touching energy"; but others are starting to dip a toe in as energy keeps getting cheaper. We're seeing a continued string of energy and oil and coal companies declare bankruptcy, so it's not like there isn't risk there. There really are a growing number of defaults and bankruptcies.
Benz: How about bank-loan investments? We've seen some volatility there as well. What's the connection?
Kinnel: Bank loan also is about yield. There is some credit exposure. Generally, bank-loan funds do not have as much credit risk. They are a little higher quality than high-yield funds, but they are still related, and I think they also sort of fit that chase for yield. Yield-hungry investors have gone after high-yield funds, bank-loan funds, and then in 2015 we saw that trend really reverse as people got out of those. Now, one area in which bank-loan funds are also different, though, is that the yield can rise as interest rates rise. So, there is a nice component that it can protect you a little in rising-rate environments; but again, more recently, slowing economic growth means maybe interest rates are less likely to rise. So, that dims the appeal of bank loans--at least in the short run.
Benz: So, for investors who want to have these investment types in their portfolios, what should be their takeaways from this period of rough performance?
Kinnel: Well, one is the very simple one that higher yield means greater risk, generally. So, if you are looking for a high-yield fund and you start by ranking on yield or looking at the highest-yielding funds, you are essentially saying, "Give me the highest-risk funds--give me the junkiest funds." That's generally not a good way to do it. I think people forget that total return is an important part of the income solution, and you really want a fund that can preserve capital as well. So, often the best investments within high yield or bank loan are those on the conservative side. So, I think that's one takeaway.
We talked about commodities being in a very long bear market. For high yield and bank loan, it's really a more-recent dip. So, I wouldn't necessary say this is the greatest buying opportunity ever, but it is worth keeping that in mind as you build the income part of your portfolio. Say you've just hit retirement, you should also think about total return, also think about capital preservation.
Benz: Russ, tough market for anyone in anything that's commodities related. Thank you so much for being here to provide a round-up.
Kinnel: You're welcome.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.
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