Equity Portfolio Diversifiers, Tips on TIPs, and Fund Picks
On this week's podcast, custody banks, the costs of poor timing, and Ariel's take on the market.
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Connor Young: Hello. I'm Connor Young with Morningstar. I'm here today with Rupal Bhansali, manager of Ariel International Fund and Ariel Global Fund.
Rupal, thanks for joining me.
Rupal Bhansali: Happy to be here.
Young: So, global stocks have risen in 2019, but there's certainly issues investors are worried about. What is your take on the markets today?
Bhansali: Well, Connor, like Morningstar, we care about managing the risk-adjusted returns, not just returns. And I believe the market is simply not paying sufficient attention to risks, and many are growing. In particular, I think, the markets are disregarding balance-sheet risk. There's so much focus on earnings risk: Did a company meet earnings? Beat earnings? Miss earnings? And yet, few people think about: Did a company have difficulty repaying debt? Or will it have difficulty in repaying debt?Refinancing debt? And I think balance-sheet risk is the biggest risk facing the markets because corporates worldwide have gone on a debt binge.
In addition to that, I think we have economic risk and macro risks because the world economy is slowing down. There is a very dramatic slowdown in Europe, led by Germany, and I think that's going to cross over to the rest of the world. And I think, in that context, it would be well advised--investors would be well advised to invest in more of the defensive portions of the market and the noncyclical portions of the market. For example, our portfolios are particularly overweight sectors like telecommunications, which we think is a new consumer staple, and we are underweight cyclicals such as industrials, materials, banks, because they tend to suffer a whole lot more when the economy slows down.
Young: Rupal, thanks for your insights.
Bhansali: Thank you.
Young: For Morningstar, I'm Connor Young. Thanks for watching.
Christine Benz: Hi, I'm Christine Benz for Morningstar. The average investor has lost about half of a percentage point per year to poor timing decisions over the past 14 years. Joining me to share some research on this topic is Russ Kinnel. He's Morningstar's director of manager research.
Russ, thank you so much for being here.
Russ Kinnel: I'm glad to be here.
Benz: Russ, it's Mind the Gap time. You do this study every year where you attempt to measure how much investors have actually cost themselves with these poor timing decisions? Can we just start by talking about how you measure this? What do you do to look at the data to draw some conclusions on this front?
Kinnel: We're essentially looking at the fund's official returns, and then we're adjusting that for flows in and out of the fund on a monthly basis. And that way we come up with what did the average investor do, versus what did the fund's official return do. And then we roll all that up using--we asset-weight the investor returns, we average the fund returns to see what are those gaps really like. And then, we drill down and see what are some factors that might have a role in why people don't get the most out of their funds.
Benz: To use a simple example, if a fund had a great return, but I got there late before all the money had been made, my return would be smaller than the fund's published return. That's how this works, right?
Kinnel: That's right. And, of course, that's human nature, that performance affects the way we invest. And so, it's not uncommon for a fund to have great returns. Money comes in, then the returns are not so great. Money goes out, then returns are good again. So, we all have a timing challenge. And it's not just individual investors--financial planners have this problem, institutional investors. It's everyone. So, I don't want to make it sound like this is dopey individual investors. And I think a little of that cost is almost inevitable. But it's worth understanding that and as well as trying to improve how we do with our timing.
Benz: Right, which is one of the goals of your annual research. So, at the category level, or at the asset class level, let's start with a good news story. And this has been a pretty consistent finding from year to year, where the funds that bundled together different asset classes, whether balanced funds or target-date funds, they tend to look pretty good from the standpoint of investors actually capturing what their funds earn.
Kinnel: That's right. Allocation funds have the smallest gap almost every time we measure that. And I think there's a couple of factors in this. One is, as you say, they're combining a bunch of different asset classes. And when you do that, generally you have less-volatile returns. If you've got, let's say, a classic 60-40 portfolio, 60% stocks, 40% bonds, then you hit a down market, the bonds are going to provide some ballast and hopefully make money, but if not, at least lose less than stocks. And so, that provides a smoother return, which means our timing is less important, and also doesn't trigger those emotional responses of fear or greed if it's kind of boring relatively steady returns. Even a 60-40 portfolio is still going to be somewhat volatile, but people do better when things are a little more stable and the timing is really less important.
Benz: Could another factor be that people sometimes own these multi-asset funds, especially target-dates within the context of a 401(k) plan, where they're maybe putting their money in and kind of tuning out?
Kinnel: Yeah, that's the other big piece of that story is that not only do you have better funds for people, but you have this great vehicle of 401(k)s, where people invest steadily. And so, really, I think of when you have a target-date fund, which is a kind of boring, super-diversified vehicle, and you have a 401(k), it's really the best investors coming to beat the best-designed funds. And you have these really good results, because people just keep plugging their money away. We saw that even in the bear market of 2008-09, almost everyone kept plugging away and putting their money to work, whereas hardly anyone with discretionary money was doing that. And so, yeah, it really tells us a lot about where we should head and what are the best practices, because I think really, the more steady we can invest and the better diversified our portfolios, the better results are going to be.
Benz: Another asset class, on the bad news story would be the alternative funds do not look good from the standpoint of investor returns. What's going on there?
Kinnel: Alternative funds have really been a disappointment on a lot of levels. So, for one thing, most alternative funds have lost money or made very little money over the last 10 years. And then, on top of that, investors' timing has been really bad. So, you put the two together, and you have some really bad experiences for investors. And I think part of it is, people entered alternatives, especially early on at the time period we measured, kind of thinking this was the best of both worlds that you get all the market's upside, but then not the downside. But in fact, it's much less that--you have much less upside, and you still get some downside, even if it's not necessarily market-driven. But most alternative funds do lose money from time to time.
And then, I think on top of that you have the complexity makes it hard for investors to do well. And so, we talked about how investors sometimes go in after good performance and out after bad performance. That's really magnified in alternatives funds. So, you see funds have good performance, money comes in, they do poorly, money goes out, and then those funds never come back, which is different from the standard equity, fixed-income world. So, really, I think there's a lot of challenges for alternative funds. On the one hand, the returns are disappointing. On the other hand, investors did really poorly timing it. So, really bad results. And so, I think it speaks to how the investment world needs to do a better job with these funds.
Benz: Well, that's the thing. A lot of these funds were marketed in the wake of the bear market, maybe their days of delivering high utility were behind them for some of those categories. So, I think that the industry definitely shares some blame here.
Kinnel: For sure.
Benz: You also cut the data in different ways beyond the asset class and category level. You looked at volatility, which you've kind of hit on already, that there seems to be a connection. Low volatility, chances are investors are going to do better.
Kinnel: That's right. So, when we group funds by volatility within an asset class--rather than just a category, we do it within an asset class--we find the more-volatile funds have a bigger investor return gap. Investors don't use them as well. And obviously, the more volatile a fund is, the more important your timing is. So, that's part of it. And then, the other part is just, they do tend to spur a fear or greed. You think about a tech fund or an emerging-market fund and one year they are up 50, the next year they're down 20. And so, it's hard to hold on. It's hard to time those well. And so, naturally, we see that play out in investor returns.
Benz: One thing that was somewhat surprising to me is that better investor returns appear to be associated with lower-cost products as well. That one's a little less intuitive. Let's walk through that conclusion.
Kinnel: That's right. So, of course, we know that lower-cost funds tend to have better total returns.
Kinnel: But then they also have lower gaps, which means that the investor return is greater not just by the fee, but also because of the gaps. And so, the difference between an investor return in a high-cost fund and the low-cost fund is significantly greater than fees. And I think we talked a little earlier about the confluence of good investors and good products. I think that's part of what's going on here, again, is that people are smart enough to look for low-cost funds tend to use them more wisely. Of course, index funds are a piece of that story. Those are not the most exciting investment vehicles. But people have done a pretty good job of standing pat with those funds. And of course, I think lower-cost funds tend to have better performance. And so, there's a nice reinforcing mechanism there, that people feel rewarded for investing in lower-cost funds. Higher-cost funds tend to take on more risk. They tend to disappoint people and cause people to get out.
Benz: I want to talk about a couple of specific funds that you have highlighted as having especially good investor returns, meaning good investor outcomes. Let's start with Vanguard Explorer. This is kind of an all-in-one small- and mid-cap fund. Investors have done a good job of capturing that fund's very strong returns.
Kinnel: That's right. And it circles both points we made earlier. It's very low-cost, about the cheapest actively managed funds you could get, and almost as cheap as a lot of index funds in small-cap space. So, very low-cost, which means it can more often have outperformance, but it's also boring. It's really boring. It's spread out across a lot of subadvisors with a very diffuse portfolio. That's again, it's not so different from an index fund. And so, I think investors have timed the fund pretty well, because it isn't exciting. It doesn't make you want to rush into it. It doesn't make you think you're going to get rich quick. And so, that's actually worked to investors' favor.
Benz: Fidelity Growth Company is another one. This is a fund that actually employs a pretty aggressive strategy. But it looks good from the standpoint of investor returns. What's going on there?
Kinnel: This one isn't boring. The returns have been great. But obviously, there are sometimes when it gets smacked. And anytime large growth is going to get hit, this fund is going to get hurt. But I think one of the things that's really worked in its favor besides having good returns to begin with, is that the fund has been closed for a long time. And we've noticed that funds that are closed to new investment, tend to have pretty good investor returns. And I think there's a couple of things going on there.
One is simply that you're keeping the--they're preserving the strategy. You're preventing the fund from getting so big the manager can't run it. But maybe the more important piece is that it keeps investors from rushing in at the worst time. If you've closed the fund, and let's say, it then has another two really good years, so in this case, we know growth has had a very long run with companies like Apple and Amazon leading the way, but you couldn't get into this fund after they had those great results. And so, it keeps investors from coming in at the worst time, and I think it maybe keeps some of the hot money out, which also on the flip side is prone to leaving at the worst time as well. So, closed funds are another investor-friendly practice that really matters for investors.
Benz: Russ, this is always fascinating research. Thank you so much for being here.
Kinnel: You're welcome.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.
Susan Dziubinski: Hi, I'm Susan Dziubinski for Morningstar.com. With the equity market rally in its 11th year, many investors may be wondering if the end of that rally could be around the corner. And if it were, how would their portfolios respond? Here with me to talk about some of the best diversifiers for an equity portfolio is Christine Benz, our director of personal finance.
Christine, thanks for joining me today.
Christine Benz: Susan, it's great to be here.
Dziubinski: First, how can we tell if a given investment type offers diversification versus equities?
Benz: Well, there are a number of ways that you could try to get your arms around this. One that we like at Morningstar is a statistic called correlation coefficient. And essentially, that means that we compare two assets' performance to one another. And what we're looking for is a negative correlation coefficient. That would mean if my equities go up, X asset goes down. That's what I want if I'm looking for diversification. If we see two assets that have a correlation coefficient of 1, that means that they tend to move kind of in lockstep, that if one is up, the other is up, too. What we're looking for is that negative correlation.
Dziubinski: Now, these correlations are backward-looking, meaning they're based on past performance of these asset classes. They can't really predict the future, right?
Benz: They can't. Unfortunately, though, they're the best we've got, in terms of trying to figure out what will offer some diversification relative to the equity market. It's the closest thing that we can come to try to predict the future. And we have seen these correlations fall apart at various points in time, but we've also seen them hold up at various other points in time.
Dziubinski: You recently did some research taking a look at the different asset classes to find out which ones offered the best diversification alongside the S&P 500. And Treasury bonds came out looking pretty good on that mark, right?
Benz: They did. And that's been a consistent finding. As long as I've been measuring these correlation coefficients relative to equities, Treasuries have tended to look pretty good. What surprised me in this latest data run, Susan, was that we didn't have to venture into long-term Treasuries to capture good diversification relative to equities. Short- and intermediate-term Treasuries did the job, too. And the reason that's important is because short- and intermediate-term Treasuries are much less volatile than long-term Treasuries. The main reason most investors don't own long-term Treasuries is that they tend to have almost equity-like volatility. Well, the good news is that you don't have to venture into them to get good diversification for your equity portfolio.
Dziubinski: Now, interestingly, if you look at the asset size of various different Morningstar Categories, the Treasury categories actually don't have that many assets. It's more the intermediate-term bond core categories that hold a lot of assets. So, how did those types of funds hold up in your correlations?
Benz: Well, it's interesting and the answer is, it depends. So, within the core intermediate-term bond category, we did find some that were quite good diversifiers. So, lo and behold, a Bloomberg Barclays Aggregate Fund was quite good as a diversifier for an equity portfolio, in part because as currently constituted, these aggregate trackers are very heavily tilted towards U.S. government bonds. Other intermediate-term bond types, especially in the core-plus space, which typically have higher yields, but also venture into some lower-rated securities, those were a little less effective as diversifiers. On the other hand, you are picking up a higher yield on an ongoing basis, which should translate into a higher long-term return. The trade-off though is that you have a little bit less ballast in case of an equity market shock. So, that's something to keep in mind.
Dziubinski: Interesting. So, what other categories were maybe a little bit less impressive?
Benz: Well, probably not surprisingly, when we looked at other equity types alongside the S&P 500, you didn't get a lot of bang for your buck in terms of diversification. So, foreign stocks, for example, somewhat uncorrelated to the U.S. equity market, but nonetheless, not an extremely low correlation. Same with U.S. small-caps, not too impressive there. Also, the alternative asset class' performance wasn't especially attractive there either from a diversification standpoint. Within that space, the one category that stood out in terms of offering decent diversification benefit was--I used SPDR Gold Shares, which owns gold bullion. That actually performed decently well as a diversifier for equity exposure.
Dziubinski: Interesting. This is really great food for thought when you're thinking about how to protect your portfolio. Thanks for your time, Christine.
Benz: Thank you, Susan. Great to be here.
Dziubinski: I'm Susan Dziubinski for Morningstar. Thanks for tuning in.
Susan Dziubinski: Hi, I'm Susan Dziubinski for Morningstar.com. Sometimes a fund's long-term track record can be deceiving. A fund's style can be out of favor for a prolonged period of time, yet its approach maybe solid and its management adapt. Today, we're looking at three such funds. These funds all carry Morningstar Ratings of 2 stars or less yet earn Morningstar (fund) Analyst Ratings of Bronze or better.
Jack Barry: Silver-rated ClearBridge Aggressive Growth still has a lot in its favor despite its 2-star rating. First and foremost is the experienced management team. Lead manager Richie Freeman has been with the fund since its inception in the 1980s. He's joined by comanager Evan Bauman, who's worked alongside him for 20 years, first as an analyst and then being promoted to comanager in 2009. Both investors take a long-term approach to searching out growth-oriented companies and to consider themselves as part business owners alongside management and thus look for shareholder-friendly management teams.
Dan Culloton: It's a mistake to penalize a good value fund when value is out of favor. And that's the situation we have with Oakmark Global. It still has the same management, same experienced management, same absolute value process, same concentrated distinct portfolio. What's changed, though, is that, in 2018, it really had a rough year, primarily because of its exposure to Europe and carmakers and European financials and because it was underweight the U.S. It's been out of favor. It's been out of favor before. But its management, its process are still the same. And we think that, overall, it's still a good bet for investors who want a global value fund.
Gregg Wolper: Sound Shore Fund is a good fund, but it has not performed well the past few years. One reason is because it's a very concentrated fund. It only holds about 35 or 40 stocks usually, and the top holdings--they can get about 4% of assets. And when they don't do well, that can have an impact on performance, naturally. The managers have liked the financials, some of the big banks, for quite a long time. And when Bank of America, Citigroup, and Capital One have rough times, as they have had in the past year, so that really hits the portfolio. So, that partly explains the performance. But there's good reason to remain confident that the fund can outperform over time.
The managers have been in place a long, long time. So have the analysts. And they have remained consistent to their strategy over the years. And that is a moderate value strategy where they don't go after the deepest discounted turnaround plays. They want moderate value--meaning, undervalued stocks but that have a good financial foundation. And this has worked well over the years, and it should continue to work well in the future, given that it's a reasonable strategy and the managers and analysts have such experience putting it into action.
Rajiv Bhatia: The custody banks are really unique financial institutions. Unlike a traditional bank which focuses on gathering deposits and making loans, custody banks are in the asset-servicing business. When investors refer to the custody banks, they are often referring to banks such as State Street, BNY Mellon, and Northern Trust.
The custody banks monetize their assets in several ways. They earn servicing fees from custody and fund administration services; these fees are typically a few basis points on the assets held under custody. They earn subscription revenue from data services. They act as an agent for securities-lending activity, connecting borrowers and holders of securities. They also assist with foreign exchange trading activities. Finally, they also earn net interest income from client cash deposits.
Based on Morningstar’s moat methodology, we believe the custody banks do possess a wide moat from cost advantages and client-switching costs. The custody banks have scale from the upfront costs of developing software systems and processes to service trillions in assets. In addition, due to process disruption, onboarding costs, and a limited number of providers, the clients of the custody banks seldom switch.
That said, it’s not all sunshine for the custody banks. The custody banks face a tough pricing environment. Their client base of asset managers is increasingly concentrated, who themselves are facing significant fee pressure. In addition, clients are becoming more discerning on the interest earned on cash. As a result, we believe State Street and BNY Mellon have negative moat trends. While we believe Northern Trust’s custody segment also has a negative moat trend, we give Northern Trust a stable overall based on the strength of its wealth management franchise.
Overall, based on valuation, we currently find State Street to be the most attractive and rank it four stars. Northern Trust and BNY Mellon are both at three stars.
Eric Jacobson: When it comes to choosing a TIPS fund, the story is a little paradoxical. That's because getting your arms around the underlying mechanics and movements of TIPS bonds can be pretty complex and daunting, but picking among TIPS mutual funds is actually pretty easy.
That's because TIPS are a lot like conventional Treasury bonds, which are very uniform and don't cost a lot to trade. And even though TIPS aren't as liquid as conventional Treasuries, they are pretty easy to trade compared with most other kinds of bonds. And in the case of TIPS, there are actually only 40 of them, and they average roughly $35 billion in issuance per bond. All in all, TIPS markets are pretty efficient overall, and managers running portfolios that are limited to TIPS generally have a hard time distinguishing themselves from one another without taking on an unusual amount of risk.
As a result, there are really only two ways to go if you want to be a standout TIPS offering. One is to supplement TIPS with additional market exposures to help add excess returns and distinguish yourself from plain-vanilla competitors and index funds. The other is to run portfolios close to or in line with indexes and charge as little as possible.
And when you look at favorite TIPS funds among Morningstar analysts, that split is pretty evident. The funds that our analysts rate most highly tend to either have very low expense ratios or have proven they can produce better returns than TIPS index offerings by taking on some--but not excessive--extra risk.
Two of our most highly rated picks are run by Vanguard. One is Vanguard Inflation Protected Securities, and the other is Vanguard Short-Term Inflation-Protected Securities Index Fund. Schwab offers a TIPS ETF that only charges 5 basis points and also gets one of our highest ratings.
On the other end of the spectrum is PIMCO Real Return. That fund charges well more than the average plain-vanilla or index offering, but it isn't overly expensive at the end of the day and benefits by supplementing a basic TIPS portfolio with other PIMCO bets designed to give the fund a leg up.
All in all, there are roughly 60 different TIPS funds out there, but only a handful really deserve your attention.
(Disclosure: Eric Jacobson owns shares in PRRIX, a different share class of PIMCO Real Return.)