In an article published in the December 2018 issue of Morningstar Fund Investor, Russ Kinnel, director of manager research for Morningstar, gave some important guidelines to answer this very crucial question:
How do you figure out if your fund’s slump is temporary or if it will continue for years.
It could be a fundamental flow or a newly developed one. Alternatively, it could be that the fund still has the same strengths and may rebound when the market changes. Those who have been investing for a while know the market can turn on a dime. In years like 2000, 2003, 2008, and 2009, winners became losers and losers winners as the market violently lurched about.
At Morningstar, we take a long-term approach, so a short-term slump doesn’t usually change our minds. That’s not always the case, however. In recent years, we’ve downgraded former favorites but are also sticking with slumping managers.
There are many angles to each fund, but here are four things I am particularly interested in when looking at a slumping fund:
- Does the manager’s long-term record still look good versus the benchmark and peers?
- Has the manager changed her strategy?
- Has the manager dug in his heels on longtime favorites rather than keep an open mind about possible mistakes?
- Has the fund lost key managers or analysts who were important to past success?
A slump isn’t reason enough to fire a fund, but it is a call to dig into the problems and re-evaluate. You may find more issues than you'd expect. My analysis reveals that even when a fund seems to be the same old holding at first glance, there may well be changes bubbling beneath the surface.
In conversation with Christine Benz, Morningstar’s director of personal finance, he explained it in more detail.
- Don’t blindly cut lose funds that have underperformed either the market or their peer groups.
You really need to understand the fundamentals and why you own the fund in the first place. Every fund is going to have periods of underperformance. You need patience and you need to really understand why the fund is underperforming. If you sell all of your losers, you may end up with next year's losers instead.
- Understand if are there new problems that this slump highlights?
Is it just that the their strategy is out of favour. The markets tend to favour certain sectors, certain strategies and therefore leave other ones out of favour. Yet, those same strategies can come roaring back very quickly because the markets rotate, they correct. Is the fund continuing to do what it's supposed to do? Are all the key people there. If all the key things are in place, you probably want to stick with it.
Look to see if the fund is losing key managers or analysts. Has the fund's process changed? Fees - sometimes underperforming funds will get a lot of redemptions and then all of a sudden, their fees are rising. This is a fundamental change because now you have a higher-cost fund and that reduces the odds of it coming back strongly.
More recently, Russel Kinnel discussed a defensive stance in a portfolio.
If you have an active equity fund, should you expect it to get defensive in preparation for a tough time? Should you expect it to move a portion of the portfolio into cash?
It is hard even for fund managers to make those market calls. Generally, most fund managers have found that it's better to keep doing what they are doing and not try and make a market call.
Most active equity fund managers are stock-pickers. They are not market callers. You could go to a tactical allocation fund if that's what you want.
If a fund has some defensive characteristics, it will probably do better depending on where the bear market hits. For instance, a fund that emphasizes high quality companies--these are companies that are generally much less hurt in recession and therefore generally do better in bear market. Or a fund might have other defensive characteristics such as some gold holdings or may hold more in cash or have other defensive characteristics. So those kinds of funds are going to do better in some downturns, not all of them.
But then your more standard fund, that's simply seeking to maximise returns over a full market cycle, there is no real reason to expect them to lose less in a down market.
So how do you build defense in your portfolio?
It's in your portfolio-building process where you build defense. What you can do is have a variety of strategies, asset classes, and industry exposure because often bear markets and recessions hit one or two industries. For instance 2002 (technology) and 2008 (financials).
Having an active manager who stays disciplined and keeps doing what they are doing, can really help you to stay diversified, just as it will with a passive fund as well.
Diversification often helps to reduce the blow--it doesn't spare you any losses. The 2002 bear market really hit growth much harder than value, and diversification really paid off. In the 2008 bear market just about all equities got hit, but fixed income at least did a lot better. Diversification helps, and that's really what to focus on.
Disciplined managers help because you don't want all your managers rushing to the hot dot, because then if that area gets hit, then you are really in trouble.
Seeking diversification at the asset allocation level-- sane asset allocation framework given age, proximity to retirement, risk capability. Within asset classes also be diversified.
If you've done that, then you are in a much better position to ride out the down market and make money in the rally. It's the people who really haven’t taken care of that plan who have the hardest time.
