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Investing Insights: Funds at Midyear and Dividend Stocks

We discuss retirement policy statements, moat upgrades, and Primecap picks on this week's episode.

Editor's note: We are presenting Morningstar's Investing Insights podcast here. You can subscribe for free on iTunes.


Christine Benz: Hi, I'm Christine Benz for Mutual fund investors have seen volatility in both their stock and bond portfolios so far in 2018. Joining me to provide a midyear recap of the action in mutual funds is Russ Kinnel. He is director of manager research for Morningstar.

Russ, thank you so much for being here.

Russ Kinnel: Glad to be here.

Benz: Russ, let's start by talking about bonds, because even though we have a few days to go here in the first half of 2018, it does seem that some of the losses that mutual fund investors have experienced have been concentrated in their bond holdings. First, what's going on in the bond world that has led to losses in bond funds?

Kinnel: We are seeing signs of rising inflation and the Fed is responding by raising rates. And so, we are seeing the long end of the bond world sell off in anticipation of more rate hikes and possibly more inflation. We have talked about the smooth ride in equities. It's even smoother in fixed income and we have barely noticed any bumps since '08. And so, it hasn't been a disaster, but a lot of bond funds are in the red this year.

Benz: In terms of the types of bond funds that have gotten hit the hardest so far in 2018, where have those losses been concentrated? You mentioned long-term has been the hardest hit spot?

Kinnel: That's right. So, if you have a long end, like a Treasury fund or a lot of muni funds are longer term, those may be down 1% or 2% this year. They are maybe doing the worst. Emerging-market bonds have also done poorly.

Benz: In terms of the types of bond funds that have held up relatively better, can you talk about those?

Kinnel: Yes. Naturally, they are at the other end of the yield curve. So, bank-loan funds, which ratchet up their rates as interest rates rise and therefore, aren't really affected by rising rates, those are doing the best. Then ultrashort bonds and short-term bonds, because obviously they have very little interest-rate exposure. And then sort of in between the good and the bad is intermediate-term bonds, which have lost more than them. They are in the red about 1.5% as we speak, but we've got a couple of days left in the month.

Benz: If investors are looking at their bond holdings, how should they be approaching them? I think some investors are very fearful about what might be next for the bond market.

Kinnel: Right. Obviously, bonds are your more conservative investment, maybe a place you go to if you need emergency cash. But I do think you should have a plan that allows for these kinds of blips. I mean, we are talking about for the most part funds that are down 1% or 2%. That's really minor. That's a regular occurrence. You certainly shouldn't be surprised by that and it shouldn't be something that upsets your plan. I think, for sure, it signals that there could be some more headaches along the way and you have to have a robust plan. I think it makes sense to be diversified, makes sense to be aware of what kind of credit risk you have, because credit risk is something that for the last few years has done really well, but every once in a while, it blows up. You want to understand your plan, but you should be able to handle these minor blows to the markets.

Benz: Maybe be careful about taking crazy amounts of duration risk, too, because you mentioned that that part of the bond market has been hardest hit most recently.

Kinnel: That's right. Every once in a while, duration risk, so long-term bonds get hit hard because inflation or interest rates spike. And so, you want to be prepared for that. Diversify not just by credit risk but also by places on the yield curve. Have some short and intermediate exposure, too.

Benz: Let's talk about equities, because equities did experience some volatility earlier in the year, like, back in February. That seemed mainly sort of inflation-, interest-rate related. More recently, some of these tariff concerns have roiled stocks. What's going on in the equity market and which types of funds have been hardest hit by some of the volatility that we have seen?

Kinnel: Yeah, you are right, we have had a few ups and downs, both individual company issues as well as some big market issues. Of course, the trade dynamics seem to change every day and therefore, that's part of why it's so volatile as that's changing. Even if you, say, had a set deal on tariffs today, obviously, it takes a while for the markets to really figure out what does that mean for all these individual companies. The companies that are more affected by these trade wars are definitely the ones whose share prices are hit harder.

Benz: One thing we've seen so far in 2018 has been the outperformance of growth stocks at the expense of value investing. This is something that's been going on for a while. What's going on there in general and how has this affected mutual fund performance?

Kinnel: You are right. Tech and healthcare are really dominant. And a part of the story is just the FAANGs continuing to be so strong. The FAANGs are Facebook, Amazon, Apple, Netflix, Google. They are doing really well and part of what they are doing well at the stake of some value names--you think of like retail, newspaper, some others--they are essentially taking business away from the value side, and that's still showing up. I am sure at some point it reverses, but once again, large value is the worst place to be. Small growth is the best place. For the year to date, small growth sort of catching up with large growth. And so, if you see, smaller-cap tech and healthcare names have really done well.

Benz: Equity investors might look at this and say, well, value has underperformed for so long, potentially, is it a place for me to be looking if I'm adding to holdings in my equity portfolio? What's your counsel there in terms of how investors should approach that value versus growth split in their portfolios?

Kinnel: Generally, you want to be relatively neutral. I am not so picky that I think you have to be perfectly split down the middle, but I think you generally want to avoid a big overweight. If say, your growth funds have really had a big ride, it probably makes sense to rebalance into some value. But to say, what does mean for the next six months or a year or two years, really hard to say. There's no reason growth couldn't continue to outperform. That's too hard to predict the short-term moves.

Benz: Then moving over to international equity funds, let's talk about what's been going on there. And you mentioned we still have a few days left in the quarter until July 1. But when investors look at their equity fund holdings right now, they are seeing some red ink. What's going on in terms of performance?

Kinnel: That's right. So, rising U.S. interest rates once again are a big deal for these overseas equities. One reason is, emerging markets are very sensitive to U.S. interest rates and dollar strength. That's hurting them. Also, you see, obviously, the trade wars affecting a lot of the markets. Then there are some individual countries, Turkey and Argentina are maybe the worst off, where they are having their own significant problems. You have got all that going on. There's some wariness of European banks and financials. And then, again, the dollar strength also means that your foreign equity holdings probably don't look so good because most foreign equity funds do not hedge their exposure. A rising dollar means you are doing worse than the actual markets themselves.

Benz: In currency-adjusted terms?

Kinnel: Right. So, that's one reason that your typical foreign fund has done worse than your typical domestic fund.

Benz: When I look down the line at different foreign equity funds, one thing I seem to see is that some of the riskier types of products have been hit a little worse. You mentioned emerging markets, why they have been hit, but it also appears that maybe some of the smaller-cap foreign names have been hit harder. What's going on there?

Kinnel: Yeah, I think you are right. Part of it is something like a risk-off movement where you move out of the riskier plays. Also, I think, again, some of the markets are just affected by the trade wars. Some of the smaller companies, it's really hitting almost random because each country is choosing different trade targets to stab at their rival and really inflict pain, and they can obviously choose anywhere in their rivals' economy. And so, that's hard to predict, but it's really affecting a wide array of companies.

Benz: Russ, thank you so much for being here to provide a midyear recap of the mutual fund market.

Kinnel: You're welcome.

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


Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. If you're approaching retirement, a retirement policy statement might be something that's worthwhile putting together. I'm here with Christine Benz, she is our director of personal finance, to talk about what it is and how to make one.

Christine, thanks for joining me.

Christine Benz: Jeremy, great to be here.

Glaser: Today we are going to talk about this retirement policy statement. You also, in the past, talked about the investment policy statement. What's the value of really putting pen to paper and creating these statements?

Benz: I think that there are a couple of key benefits to policy statements, whether for your investment program or for your retirement de-cumulation program. One of the key benefits in my eyes is simply that it gives you a chance to articulate your strategy. You aren't embarking on retirement or you aren't putting together an investment portfolio without a real plan. The IPS or the retirement policy statement helps ensure that you have a plan, that you have a strategy and you have taken time to document it.

Another key benefit in my view is that having these policy statements helps ensure discipline. If you have spelled out in your retirement policy statement, for example, that you are sticking to a 4% withdrawal rate system--well, the fact that you've committed that to paper is probably going to keep you on track with that system a little more than would be the case if you hadn't laid out any documentation. The same would go for crafting an asset allocation framework and spelling it out in your investment policy statement. The fact that you've written down that you plan to stick with a 75% equity allocation, 25% bond allocation will tend to keep you on board with that asset allocation program a little more. Those are two key benefits.

The final benefit that I see to having these policy statements is simply to give your loved ones the ability to get a quick and easy glance at what it is you are doing in terms of how you are approaching your investment program or how you are approaching your retirement plan.

Glaser: What sort of things should go into the statement? You mentioned a few earlier. But what would the full thing look like?

Benz: Looking specifically at the retirement policy statement, obviously, you would want to have the basic outlines of your retirement program--when you plan to retire, when your spouse plans to retire; the key assets that you will be bringing into retirement; you want to articulate your anticipated income needs in retirement; how much of those income needs will be coming from certain sources of income like Social Security, like a pension, like an annuity. Then you will want to articulate your specific withdrawal plan for that portfolio. Not only how much you plan to take out of your portfolio but also how you plan to actually extract that cash flow. Will you focus strictly on whatever current income your portfolio kicks off, or will you reinvest all of your income back into the portfolio and use a pure total return approach where you are just withdrawing rebalancing proceeds. You are really spelling out the nitty-gritty of your spending plan and how you are extracting that cash flow from the portfolio.

Glaser: How does this retirement policy statement interact with your investment policy statement? Does it supplant it? Do they live side by side? How would you think about that?

Benz: I see the two as very much living side by side. Even though you maybe retired, you still are managing an investment portfolio and the same types of considerations that influence your decision-making when you are in savings mode will still be in play when you are retired. In the investment policy statement, you are getting into what's my asset allocation that I'd like to maintain; what are the investment criteria that I'm looking for when I pick investments; how do I decide when it's time to sell? All of those considerations are getting spelled out in the investment policy statement, and they are still important in retirement.

The retirement policy statement, I would say, is a little bit more holistic in that it considers not just the investment portfolio but the nonportfolio assets as well--things like Social Security and your approach to it. Those are the types of things that would get documented in the retirement policy statement. So, it's de-cumulation-focused. It's a little less focused on the specifics of managing that investment portfolio on an ongoing basis.

Glaser: You've created a downloadable template for this. It's available on But if you did want to have some customization, what are some of the areas that you might consider adding on?

Benz: A couple of key areas come to mind. One would be for people who are adherence to the Bucket approach that I write a lot about for The basic idea would be that if you wanted to put a little appendix on your retirement policy statement that gets into the specifics of: here are buckets, here's the general character of the investments that I intend to put within each of these buckets, that would be one way to customize a retirement policy statement.

Another idea that comes to mind is--and this is a really common situation, where you have two spouses where one is the very engaged investor and maybe you've got another spouse who is not that engaged or maybe not even that knowledgeable about investments--you might want to lay out a quick and dirty retirement policy statement, maybe something a little easier to understand, more condensed, easier to skim that gets into the broad outlines of your retirement de-cumulation plan. I think that can be very valuable if you happen to be part of one of those couples where you have a spouse who is just not that into it.

Glaser: Christine, thank you.

Benz: Thank you, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.


Erin Lash: Attractive dividends abound in the consumer products realm, and given the recent erosion in shares, we think investors would be well-served to feast on these three undervalued, wide-moat names: Procter & Gamble, General Mills, and Coca-Cola.

P&G has pampered investors with a stream of dividends for the past 130 years, and with the yield hovering around 4% and our outlook that returning excess cash to shareholders will remain a priority, we think investors should add this wide-moat name to their shopping cart. While shares trade at a more than 20% discount to our $98 fair value estimate, we don't believe the recent pullback has reflected an erosion in the firm's competitive edge, but rather is due to the languishing top-line performance which has plagued operators across the industry. Moreover, we believe the firm's efforts to right-size its brand mix over the past several years will position it to focus its brand investments on the highest return opportunities and ensure that its mix better aligns with evolving consumer trends, bolstering its sales momentum and supporting the entrenched retail relationships that underlie its wide moat.

But attractive dividends aren't limited to the household and personal care space; rather investors craving dividends would also be wise to order up packaged food names, including General Mills. We think the market's confidence in this wide-moat firm's ability to restore top-line growth has faltered, considering continued softness in volume across the industry as well as skepticism around the acquisition of natural pet food company Blue Buffalo earlier this year. While the deal carries some inherent risk as General Mills enters a category in which it has limited experience, we remain confident in the firm's ability to efficiently integrate Blue Buffalo and extract cost synergies from combining these operations. Further, we don't portend its appetite for acquisitions will come at the expense of returning cash to shareholders. Given its discounted price, trading about 25% below our $59 fair value estimate and with a 4%-plus dividend yield, we think the stock provides an attractive entry point for long-term investors.

Finally, we suggest investors thirsting for dividends look to Coca-Cola, boasting a dividend yield of more than 3.5%. As one of the world's top beverage manufacturers, Coca-Cola benefits from an unmatched distribution network. And while we surmise that concerns surrounding soft price/mix have weighed on shares of late, we attribute this to a shift in geographic mix toward developing markets rather than an erosion in the pricing power afforded by Coca-Cola's substantial brand equity. Further, we don't think the firm is merely resting on its laurels, but rather is looking to drive improvement through new product innovation and distribution growth. As such, with shares trading around a 15% discount to our valuation, combined with our expectations for mid-single-digit annual growth in its dividend over our forecast, we think investors should build a position in this wide-moat name.


Seth Sherwood: Arrow Electronics and Avnet are two of the world's largest value-added distributors of electronic components including semiconductors, capacitors, interconnect products, and in Arrow's case, a provider of enterprise computing solutions. We believe both firms will maintain their places at the top of the distributor pile due to significant cost advantages over broadline distributors who may attempt to add their own value-added services and suppliers who may consider bringing such services in house. We believe this warrants an upgrade to a narrow moat rating for both firms.

Both companies have focused on improving their value-added services, such as component testing, design-chain support, supply-chain management, and other engineering-intensive offerings. However, the two firms have invested in maintaining their moats in different ways.

Arrow has used its strength in components and enterprise computing to become a "solutions provider." The firm has invested heavily in engineering expertise to become the central hub between semiconductor suppliers, software vendors, IT re-sellers and customers. We believe the firm's expansive offering of services and end-to-end solutions has it on target to generate excess returns over our forecast.

Avnet by contrast has doubled-down on components distribution, selling their own solutions business in 2016 and acquiring online distributor Premier Farnell. The firm is evolving as a value-added distributor by targeting makers, startups, hobbyists and other low volume customers via the additional acquisitions of and Dragon Innovation, as well as securing a partnership with Kickstarter. We think these moves will help Avnet capture customers at an earlier stage, growing with startups as they scale from ideation to full-scale volume production.

Both Avnet and Arrow have been caught in the middle of considerable supplier consolidation in the semiconductor industry, and we expect the threat of consolidation to remain a worry for both firms. That said, we think it unlikely that many suppliers will follow Texas Instrument's example and reduce Arrow and Avnet to fulfillment distributors due to the significant investment and time required. In the end, we believe the demand for increased electronic content will continue amid secular tailwinds such as the "Internet of Things," enabling long-term demand for the services and engineering expertise of both firms.


Alec Lucas: Since its 1983 founding, Pasadena, California-based Primecap Management Company has established itself as a premier asset manager. The firm has two strategies open to new investors: Primecap Odyssey Growth, which has a Morningstar Analyst Rating of Gold, and Primecap Odyssey Stock, which also has a Morningstar Analyst Rating of Gold. Both funds share the same veteran, four-person management team, employ a multimanager approach that divides each fund's asset base into separately run sleeves, and have below average fees versus similarly distributed peers. 

Where the two funds differ is in their mandates. Odyssey Growth focuses on mid- and large-cap stocks that the managers believe have above-average growth potential not reflected in the current market prices, whereas Odyssey Stock tends to invest in more stable, large-cap companies that are attractive for a variety of reasons, including faster than anticipated growth potential, superior profitability, and undervalued assets. 

The mandates overlap, as do the fund's holdings. In March 2018, the two funds had an active share of 50%, a figure that includes both holdings shared in common and the respective weights of those holdings. In the end, though, Odyssey Growth has a more aggressive profile than Odyssey Stock. In March 2018, for example, Odyssey Growth had a combined 34% of its assets in small- and mid-cap stocks, and the volatile biotech stock Nektar Therapeutics was its top holding. In contrast, Odyssey Stock then had about 10% of its assets in small- and mid-cap stocks, and its top holding was JPMorgan Chase.

Both funds have outstanding track records versus their respective Morningstar Category peer groups and benchmarks--large-growth and the Russell 1000 Growth Index for Odyssey Growth and large-blend and the Russell 1000 Index for Odyssey Stock. Both funds are excellent long-term options. Deciding between them comes down to one's risk tolerance.


Christine Benz: Hi, I'm Christine Benz for Your mutual fund may be more globally oriented than it first appears. Joining me to discuss some new research on that topic are two Morningstar analysts, Robby Greengold and Alec Lucas.

Gentlemen, thank you so much for being here.

Robby Greengold: Thanks for having me.

Alec Lucas: Thanks for having us.

Benz: Robby, let's start with you because you have been looking at this issue of country of domicile which is historically how we have thought about labeling mutual funds as either U.S. or foreign stock. You have looked at some different ways of perhaps determining how global portfolios actually are. Let's talk about that. Let's talk about how a fund that we might have classified as U.S. stock might actually look pretty global when you unpack where it's actually sourcing its revenues.

Greengold: That's right. American companies today, iconic American companies, have become increasingly global in their sales and operations. McDonald's, for example, the fast food chain based in Illinois, McDonald's derives only about a third of its total sales from the U.S. Johnson & Johnson, another American brand, it sells just as much abroad as it does at home. And the tech giants, American tech giants like Apple, Facebook, Google--they all have significant exposure to international markets.

This is a story about portfolio diversification. Traditionally, investors have sought to diversify their portfolios by looking at where is this company based. If I'm looking to own a basket of stocks, I'm going to look to own a basket of stocks domiciled in country A instead of country B. Given the perhaps diminishing relevance of country of domicile, another critical tool that investors should be aware of is the ability to look at what their underlying stock exposures are to the end markets that are deriving the revenues.

Benz: Alec, it's not that we are going to take away country of domicile as a tool that investors can use to sort of look at how global their portfolios are or are not. But we are actually adding this revenue lens as maybe an additional way to look at how global a portfolio is.

Lucas: As companies have become more multinational, they have begun disclosing where their revenue comes from, and that's become an important lens and one that's helpful and additive. At the same time, domicile is important, too. There are some assumptions in the way that we come up with revenue exposure. If it's a certain region, we will weight it by GDP. There are some assumptions built in. There's limitations to what we do. We think the way that we are doing this is consistent and fair and very helpful, but there are limitations. It's important to point out there's limitations to domicile as well. Some companies' domicile isn't necessarily an accurate depiction of the complexity of its operations.

Broadcom is a good example. It's a company that has its origins as a division of Hewlett-Packard in the 1960s. It's a company that's been built up through multiple acquisitions. Its ticker is AVGO, which is a heritage to the company's former name, which is Avago Technologies. They acquired Broadcom, took its name in the 2015-2016 period and recently in April shifted their headquarters from Singapore to the U.S. This is a company that gets 50% of its revenue from China and about little less than 10% from the U.S. and yet, it's a U.S.-based company. This is a good example of how there's limitation to domicile.

There's other examples. Ferguson supplies building and plumbing supplies. It's based in London, but it gets most of its revenue from the U.S. We feel like for companies like that you really want to focus on revenue. But domicile still matters in terms of investor protection and there's certain countries where the laws are not up to par with developed nations and you want to be cognizant if a company is headquartered there.

Benz: Good point. We are going to be providing this data in the products later in the year where people will actually be able to look at their mutual fund portfolios with this revenue lens. Let's give an example though right now of a fund that might appear to be a domestic fund, we've got it classed as a domestic fund, but one that actually holds companies that are quite international in terms of their revenue exposures.

Greengold: Well, one good example would be Harbor Capital Appreciation. This is a domestic fund. We rate it Gold. Looking at the portfolio, you see a lot of U.S. exposure; 90% of the portfolio appears to be domiciled in U.S. companies. Yet, when you look at that same portfolio through the lens of revenue exposure, this is a fund that generates just about half of its aggregate revenues from foreign markets. 

Investors in the foreign stock category might also be surprised at the U.S. exposure that they have. For example, MFS International. It's a Silver-rated fund that appears to own not a single U.S.-based company, and that's true. But still this is a fund that generates a quarter of its aggregate sales from the U.S. market.

Benz: There are examples on both sides. You've got U.S. funds with heavy foreign revenues, and you've got foreign funds with heavy U.S. revenues?

Greengold: That's right. It's important for investors to realize because if they are targeting an international market in their mixing and matching of fund managers, then it's important that they realize that perhaps that international stock fund is giving them exposure to the market that they are specifically trying to diversify from.

Benz: Right. And it could also be an explainer at various points in time about why your funds are performing as they are. If your U.S. fund isn't performing that well in a U.S. market that's really strong, it may be that some of its holdings have heavy overseas exposure and that's what's driving the results.

Greengold: That's right.

Benz: Another thing I want to talk about is value versus growth. When you looked at the revenue exposure of U.S. value funds versus U.S. growth funds, did you find any patterns there in terms of their international exposure?

Greengold: Yeah. We found that large-growth funds typically appear to invest mostly heavily in overseas markets. The other side of that is small value funds which appear to cling most closely to their domestic market. There are a few key reasons for large-growth funds to prefer foreign markets. One reason is that, well, they focus on large companies and naturally a large multinational is going to have a grander and global scale of operations. Growth funds are looking for where the highest growth markets are going to be, and they are looking to invest in those companies that are going to benefit from that underlying economic growth. Often, that's not in the U.S.

Also, large-growth funds are typically benchmarked against the Russell 1000 Growth Index; a significant share of that index is comprised of tech companies. Information technology lends itself more easily to foreign markets because of the nature of their business model. Many of these companies, their intellectual property is at the core of their business model, and their intangible goods can be more easily sold to international markets. Another reason why value investors might be investing more domestically is because financials are such a large part of the Russell 1000 Value. Banks and other financial institutions don't often do business in overseas markets.

Benz: Alec, when investors do get their hands on these data and I know they are coming later this year, a question is, if I see a fund that I had heretofore thought of is kind of a domestically oriented fund, is it a red flag or a reason for concern or a reason to expect higher volatility, if through this revenue lens it looks like it's actually a pretty global portfolio?

Lucas: I think it's really important to understand what you own and what's driving the exposure. Robby mentioned Harbor Capital Appreciation. It had big stakes at the end of the year, last year, in Tencent and Alibaba. Wwhat's interesting about those companies in contrast to a lot of companies domiciled overseas that might be multinationals and have pretty broad revenue exposures, in both of those cases the vast majority of their revenue is from China itself. So, in that case, that's a domestic fund where there is a lot of country-specific risk. I think that it's quite helpful to add this revenue lens and to drill down to individual holdings which we will eventually be able to do. Robby mentioned financials. A lot of times financials in the U.S., a lot of their revenue is from the U.S. There are exceptions. Citigroup has a pretty significant percentage of its revenue outside the U.S. If your fund has a big holding in Citigroup as opposed to JPMorgan Chase, then you should know and you will be able to verify that you've got more overseas revenue exposure than you otherwise might have.

Benz: Really interesting data. I'm excited to see it. I know it's something we've been talking about for a long time. Thank you both for being here to discuss it with us.

Greengold: Thank you.

Lucas: Thanks for having us.

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