WSW: Louis Rukeyser's Wall Street Summary & Discussion $treet: The Best Fund Hits

» Normxxx - The Best Fund Hits

By Don Phillips | January, 2005

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With Louis Rukeyser continuing to convalesce, Don Phillips, managing director of Morningstar, serves this month as guest commentator.

The turning of the calendar to a new year prompts many investors to review their portfolios. This is a wise practice for anyone, but an especially prudent one for mutual-fund investors. Funds aren’t static, after all. Managers come and go; strategies can evolve and change over time. An intelligently diversified portfolio of funds at the point of assembly may in later years evolve into a big and unintended bet on one style or sector of the market. So long as the sector is in favor, the portfolio looks great, but should market sentiment change, the whole portfolio may suffer—a lesson too many investors learned the hard way when tech stocks collapsed in 2000.

The good thing about reviewing your portfolio at this time of year is that newspapers and finance magazines are full of profiles and lists of the past year’s top-performing funds. The danger, however, is that these lists may tempt the more casual investor to pile into funds with similar strategies, thus undermining efforts to diversify. It’s a classic mistake. Investors load up on funds from the list of last year’s leaders, not appreciating that the reason the funds are on the list together is because they hold similar securities and take similar risks. Investors think they are diversified because they buy funds from multiple management companies with different sounding names and objectives, but if the funds are on the leaders’ list in the same year, there’s a good chance that the investor is buying different shades of the same basic style, rather than getting real diversification.

I’ve seen this situation so often that I’ve become convinced that I can carbon-date portfolios. When I see a portfolio full of growth and technology funds from providers like Janus, AIM and Turner, it’s a safe bet that the investor assembled the portfolio in the late 1990s. Similarly, if I see a portfolio full of real-estate and small-cap-value funds from Cohen & Steers or Royce, it’s likely the investor assembled or reconstructed the portfolio over the past year or two. In both cases, the investor is buying good funds, but good funds alone don’t ensure a good portfolio. To be properly diversified, an investor must have exposure to areas that have been out-of-favor in the recent past, not simply hold a batch of recent winners.

When you buy a mutual fund, in part you’re paying for a manager to try to find the next hot area for you, so to some degree it is the manager’s responsibility to steer the fund toward discounted sectors. Still, it’s important for a fund investor to understand just how much latitude a given manager has. Few managers today consider it their mandate to scour the full market for opportunities. Most managers specialize in certain areas: convertible bonds, small stocks, growth stocks, etc. Moreover, no manager knows which other funds you hold alongside his. It is up to the fund investor to monitor his overall exposure to broad parts of the market.

This issue may be especially timely right now, as there’s been a long and pronounced difference in the performance of large stocks versus small ones and of growth strategies versus value ones in the United States. Over the past five years, stocks in the Morningstar Small Value Index have risen more than 18% a year. At the same time, stocks in the Morningstar Large Growth Index have declined nearly 15% a year—that’s a stunning 33 percentage-point differential per year compounded over five years. Even conceding that large growth stocks were considerably overvalued at the start of the period, that’s a phenomenal performance difference—and one that is clearly not sustainable.

In such an environment, it’s likely that many investors, even those who have made no trades in years, today have radically different bets in their portfolios than those they intended. An unaltered fund portfolio that was well diversified five years ago, today likely has a marked bet on small-cap value stocks, just owing to market forces. So long as the trends favoring small value hold, this is a great positioning, but should sentiment shift, such an investor could be left behind.

And there are signs that such a shift may be near. Fund managers who run small-cap value funds are closing their doors right and left, citing the scarcity of attractively priced stocks in their part of the market. One top small-value manager even went so far as to urge shareholders to consider buying his firm’s growth funds, rather than send more money his way. At the same time, we’re hearing more bullish sentiments from large-cap growth managers than we’ve heard in years. Top investors like Marsico Funds’ Tom Marsico, who played cyclical or defensive stocks in recent years, are now locked and loaded with classic growth fare. Similarly, more-flexible value managers, such as Bill Nygren of Oakmark, are shifting their sights from buying good businesses at cheap prices to buying great businesses at good prices—a concession to the attractiveness of some growth stocks in today’s market.

The early phases of this economic recovery have favored deep-value strategies, but as we move along in the cycle, companies that offer good internal growth are likely to be more prized. The rising tide that has floated the fortunes of lower-quality businesses may have crested. Going forward, it will likely be of greater importance to buy better businesses, a trend that should benefit growth strategies in general and larger-cap ones particularly.

No fund company is going to run an ad today touting the big losses that their large-growth funds have produced over the past five years, so it’s likely that this opportunity will go unnoticed by many. While the exact timing of a change in market direction is impossible to tell, this is not the time to be markedly underweighted in large, quality growth stocks. Now may be a wise time to consider trimming back your small-value winners and redirecting some of those proceeds to bigger growth fare. American Century, Janus, T. Rowe Price and Fidelity all have excellent large-cap growth offerings. And, as an added bonus, many of these funds still hold tax-loss credits from bear-market losses that may make them particularly tax friendly to investors buying in today.

Finally, no conversation about big names and quality would be complete without a tip of the hat to Louis Rukeyser. Lou, our thoughts are with you. I know I speak for millions of viewers and readers when I say that your voice of reason is sorely missed in today’s market. Please get well soon!

The contents of this letter/report does not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

The content of this message is not to be construed as constituting market or investment advice. It is intended for educational purposes only. Individuals should consult with their own advisors for specific investment advice.

-- posted by Normxxx