Morningstar statistics such as downside capture ratio and average moat rating can help investors gauge how well a fund may hold up in a downturn.
Christine Benz: Hi. I'm Christine Benz for Morningstar.com.
The European debt crisis and concerns over slowing economic growth have hit stocks hard. Joining me to discuss some recent trends in the performance of mutual funds, as well as how to stress test your own portfolio's recession resistance, is Shannon Zimmerman; he is associate director of fund analysis for Morningstar.
Shannon, thank you so much for being here.
Shannon Zimmerman: Glad to be here, Christine. Always nice to be on the set with you.
Benz: Well, it's not been a great period for equity fund investors. So, I would like to quickly discuss some of the fund types that have been hardest hit among this recent leg down that we've taken.
Zimmerman: In all of the domestic equity categories that we track here at Morningstar, all of them declined over the last four weeks between about 6% and 7%. And you had large-caps and mid-caps, mid-cap growth, I think, or mid-cap blend was the worst-performing category over the last four weeks. But between 6% and 7% was the sell-off.
And the international categories fared even worse; even some of the big categories--large-cap growth and foreign large blend--declined by almost 10% each. And so that's a big hit, but not surprising given what's going on in Europe right now and the ongoing drama of the euro and the eurozone.
Benz: So, there has really been nowhere to hide if you've been an equity fund investor?
Zimmerman: If you are an equity fund investor, that's exactly right.
Benz: But you also note that there are some types of funds that have held up relative better...
Zimmerman: Government bond funds, what do you know.
Benz: And the longer you were, the better you've done.
But in terms of equity funds, quality has fared relatively better, it sounds like?
Zimmerman: That's true. There are a couple of funds that in relative terms bucked the trend. I'm going to mention two funds, and each of them lost about half as much as their category norm. One fund is Yacktman Focused. It's a concentrated fund, and you'd think that the concentration would lead to greater volatility, but really it hasn't over time. The fund held up better over the last four weeks because the strategy--and Don Yacktman is the leader there of that fund. He likes to say that he wants to buy dollar bills for 50 cents. So, there is a big margin of safety built into the portfolio. So, even though it is concentrated, they do their homework, they get it right more often than not, and so they have some cushion whenever the market declines. And again it lost about half as much as its typical peers in the mid-value category.
Another fund is a quant fund run by GMO, a couple of quants at GMO, and it is GMO U.S. Growth, and it's trained very much on high-quality U.S. stocks. It didn't have exposure, at least in terms of country of domicile for companies, it didn't have exposure abroad; it's exclusively trained on the U.S. And then Apple and companies like that with bulletproof balance sheets and just tons and tons of cash flow are well represented in that portfolio, and those are the kind of companies that do particularly well whenever turbulence hits markets.
Benz: That was certainly something we saw during the big bear market back in 2008, that if you did have that quality focus, a focus on wide-moat companies, you held up relatively well?
Zimmerman: Absolutely right. So, that was the classic flight to quality, and those kinds of funds did remarkably well. You think about it in terms of sectors, consumer staples not consumer discretionary and just the commodity companies, just the things that people actually need the most.
Benz: Health care?
Zimmerman: Exactly. It's a defensive sector, too. So, when 2008 happened, health care fared well and I actually didn't look at ... how health care did in the past month. But I would imagine as soon as I get back to my desk and look it up, it will have done quite well.
Benz: So, Shannon, you brought with you some thoughts on how to stress-test your portfolio. If you're concerned about these headlines that we've been seeing about slowing economic growth, how do you comb through your equity holdings and try to see if you've got a measure of recession resistance baked into your portfolio? What are some of the key metrics that you would tell investors to focus on as they are going through that exercise?
Zimmerman: The number of European banks that they own?
Benz: So light on European banks--OK, that's a good starting point.
Zimmerman: More broadly, there are three things, in particular, that I would mention, and maybe we can talk about a couple of more as well. The downside capture ratio is an important metric that we look at in the fund research group here at Morningstar, and essentially what that tells you--and you can define the period of time that you want to look at it over--and what I tend to do is to look at downside capture during a given management team's tenure to see how they have done. And what the downside capture ratio tells you is, how much the fund suffered during down market. So, if it's less than 100%, it fared better.
Benz: Better than its peers or an index or how do we do that?
Zimmerman: You can slice and dice it in a number of ways. So, typically what we do is look at the fund's downside capture ratio relative to both its official benchmark and to the category average, and then in some cases, funds really require custom peer groups, because [although] we put them in categories, they are quite unusual. The categories are so small you have to be able to make sure that you are comparing like-with-like.
So, a downside capture ratio below 100% in that case the fund has fared better than its typical peer during downturns. What you often see is that there is some sacrifice to the upside, not in every case, but in most cases.
Benz: Those statistics are alongside one another, the upside/downside capture ratio, so you can see the extent to which a fund has captured the upside and maybe minimized that downside?
Zimmerman: That's available on Morningstar.com--perhaps if you heard of this website.
Benz: Couple of other things, Shannon. You also have some fundamental metrics that you would direct people to. Moat ratings you also think are important in terms of assessing the quality of the companies that are inside a mutual fund?
Zimmerman: That's right. And that's something else that is available on the website, too. So, our equity analysts assign moat ratings to the companies that they cover. Company can have no moat, a narrow moat, or a wide moat, and what we do on the fund pages is to roll up those moat ratings and to express as a percent the percentage of assets invested in companies that have a moat rating. And so you can see how "moaty," so to speak, your portfolio is; the moatier the better for months like the last one or certainly a crisis like 2008.
Another statistic that I have done some research around--and it's predictive in a way that you do research and sometimes you confirm common sense--but sure enough, the debt-to-capital ratio, which is measure of a company's degree of leverage, can tell you a great deal about how your fund is likely to fare during a downturn.
2008 was a particular kind of downturn. It wasn't just a recession. It was a recession accompanied by a freezing up of the capital markets. And so you would assume that companies with high debt-to-capital ratios, or the funds that have portfolios where those kinds of companies are well represented, would do poorly, and lo and behold, they did. You could pretty much do a direct prediction of what your portfolio was going to do based on its average debt-to-capital ratio.
Benz: So that is not a statistic that we have available on the site, so how do investors go about getting their arms around those numbers?
Zimmerman: If you are a weekend warrior, and you want to spend some time combing through company filings or data that they make available on the fund company websites sometimes, they will include the debt-to-capital ratio there.
If you are really a weekend warrior, and you want to get out Excel, you can look at all the individual holdings, or maybe the 50% of assets invested in the top 15-20 names, say, of a fund that maps along those lines. It wouldn't take you forever, and it would be a very interesting exercise, and you could see how the degree of leverage affects your fund's performance over time.
Benz: So, I guess, the natural question is, though, do you want balance of companies that are moaty, less moaty, more highly leveraged, less highly leveraged? How do you strike that right balance?
Zimmerman: That's a great question, because there is the risk of quality, too. So, you look at 2008, it wasn't just a flight to quality, it was stampede into quality, and in 2009 it was a flight to risk. ... People should be long-term investors; your point is well taken to have a balanced portfolio, so that you are exposed both to quality and to risk at the levels that are appropriate for you, given your own risk tolerance and your timeline. You need to have both, and to be quite judicious about the funds that you pick for the risk side of the portfolio, in particular.
Benz: Maybe think about shifting more toward quality as you get closer to needing your money as you're retired. I would see that higher-quality companies might have a greater role in your portfolio than they did when you were younger.
Zimmerman: That's right. Things with a more moderate risk profile. Just as you tilt your asset allocation more toward bonds as you approach retirement, you would want to tilt more toward quality on the equity side, too.