Shining an Analytical Light on Funds

Many mutual fund investors in the 1990s have relied upon analytical tools provided by Morningstar Inc. of Chicago, an independent fund tracking firm. In particular, the company’s “star” ratings are frequently quoted in investment articles, cited in advertisements and used by many people as a quick guide for narrowing choices among funds.

John Rekenthaler, one of Morningstar’s leading researchers and most visible commentators, spends most of his time thinking about mutual funds and the financial markets. He’s a 37-year-old Seattle native who spent part of his childhood in Southern California. Rekenthaler joined the then-fledgling company in 1988 as a mutual fund analyst, after earning a bachelor’s degree in English from the University of Pennsylvania.

Three years later, he became editor of Morningstar Mutual Funds, a biweekly research guide that evaluates thousands of funds. In 1995, he was named publisher.

Last summer, Rekenthaler left Morningstar to become an investment strategist for fund company Nuveen, only to return to Morningstar earlier this summer. “Nuveen is a good company, but I felt I gave up some creativity,” he said. “I just didn’t have the same excitement level going to work.”

Rekenthaler now serves as research director for Morningstar, where he heads a five-person staff that focuses on quantitative analysis. The group’s goals include the elusive task of trying to compile optimal portfolios of funds for individuals.

Rekenthaler was interviewed by Russ Wiles, a mutual fund columnist for The Times.

Times: For investors with a long-term horizon, is the current stock market downturn a buying opportunity?

Rekenthaler: I think it’s a modest buying opportunity. I can’t join the crowd that seems to be forming who believe stocks are so cheap that they’re buying with both arms. I mean, a stock that went from $60 a share nine months ago to $100 a few months ago but now sells for $80 isn’t . . . [necessarily] a bargain.

At the end of August, the typical small-company mutual fund held stocks with an average price-to-earnings ratio of 22 [based on trailing earnings], with a P/E for the S&P; 500 of about 26. Both are certainly high by historical standards. With inflation at modest levels and interest rates already pretty low and seemingly headed lower, those valuations aren’t terrible. But they’re not cheap. The market has become fairly aggressively valued, from absurdly so.

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Times: But small stocks, and the mutual funds that hold them, aren’t so pricey?

Rekenthaler: On the small-cap side, valuations are clearly more attractive, and I’m more enthusiastic there. The main point I’d make with small companies is that they have a risk premium attached to them. People are viewing small companies as risky and have been disappointed by them. If they’re going to invest in them now, they want to see really attractive prices. That’s a risk premium. The markdowns with small stocks already have taken place.

I don’t see people perceiving the same risk with blue-chip stocks. People continue to hold high-quality growth stocks like General Electric or Procter & Gamble because they think these companies will always come back. There’s very little risk premium attached to those stocks, so I don’t see them as particularly attractive buying opportunities.

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Times: Low mutual fund cash positions--they had dipped to around 5% of fund assets recently--have been blamed for part of the market’s troubles. The fear is that with cash at such low levels, funds don’t have much additional money to keep buying stocks. Do you sense that fund cash levels have changed much since midsummer?

Rekenthaler: It’s hard for me to comment on that because we get lagging information on fund cash flows. But based on recent conversations that our analysts have had with various managers, the cash-position question seems to be a wash. Some managers have been raising cash while others have been investing more of it in stocks.

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Times: Do you sense fund investors on balance have been redeeming their shares?

Rekenthaler: Modestly. They’re somewhere between a watch-and-see mode and a paralyzed-by-headlights mode. Trading activity [in the funds] has slowed down. Investors aren’t pulling out a ton of money, but they’re not putting a lot of new money to work. That’s a typical reaction.

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Times: Does investor inactivity suggest that fund investors overall have become more patient, disciplined and, perhaps, knowledgeable?

Rekenthaler: Yes. I certainly think institutional investors were the ones who caused the downdraft. Individual fund investors tend to lag. They act in response to market moves that are caused by people with quick trigger fingers--hedge-fund managers and various institutional managers.

Fund investors certainly are more knowledgeable, patient and disciplined than in the past because the markets have taught them that buying on dips can be rewarding. On the knowledge side, there’s just a lot more information out there, and people are more experienced. I’d say that fund investors right now are a stabilizing force in the market. I’m not certain they’re the only rational ones because that would imply the recent sell-off was irrational.

Yes, pushing down the Dow Jones industrial average by 500 points in a day is silly. But the downturn itself may be justified because there’s a lot of bad happening in the world right now, outside of our comfortable continent.

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Times: Let’s talk about international diversification. Anyone who spread his or her assets among dissimilar types of funds hasn’t gained much protection this summer, as almost all stock-fund categories fell. Does this invalidate the idea of investing overseas?

Rekenthaler: No. But I definitely think that diversification has been oversold. It can be hazardous to assume that if U.S. stocks go one way, foreign stocks either won’t react much or will move in the opposite direction. That just hasn’t played out at those times when you needed diversification the most--when the U.S. market tumbled. World markets tend to go down together.

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Times: But you think international investing still may make sense?

Rekenthaler: I think there’s a place for international funds in a portfolio. But you have to look at them as two groups. The first is comprised mainly of European blue-chip companies that are similar to U.S. companies and, frankly, compete with U.S. firms on world markets in such areas as autos, drugs and banking. Really, these companies are just part of the global blue-chip pool, and I’m not sure you need to buy a European fund to gain exposure to these companies, since many of them are owned by domestic funds.

The other main group of foreign stocks focuses on emerging markets. They clearly do offer more diversification, along with a huge amount of risk. They should be treated as many people treat gold--as a small and speculative part of a portfolio.

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Times: Speaking of gold and gold funds, they also seem to have lost their diversification benefits, notwithstanding a good showing last week.

Rekenthaler: I’ve run out of excuses for gold. Actually, I ran out about five years ago. One of these days, everything else will fall and gold will rise. But I think the opportunity cost of holding gold while waiting for lightning to strike is too great.

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Times: What kind of responses might we see from fund companies as a result of finding ourselves in either a sharp correction or a bear market?

Rekenthaler: We’ve already seen a change in advertising. Prudential is running full-page ads that inform investors the company will find ways to preserve their capital, although those ads have a feeling of having closed the barn door after the horses left. Some of the other brokerages are advertising the message that investors shouldn’t try to handle things alone.

So instead of focusing on ads that tout high rates of return, many firms are highlighting their more conservative investments. Down the line, I think we’ll see more [ads for] balanced funds, more blue-chip stock funds and more market-neutral funds.

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Times: Market-neutral funds are defensive investments that utilize a lot of “short selling,” or betting on declining prices, along with regular, or “long,” stock purchases. How have they fared lately?

Rekenthaler: The Barr Rosenberg Market Neutral Fund and some others held up pretty well. I think “market-neutral funds will gain in popularity as asset-allocation funds did after the crash of 1987. You can’t sell an asset-allocation fund with a straight face these days because people don’t think asset allocators can dodge a crash. But the market-neutral approach is a new trick, and so far it has worked.

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Times: But those funds do carry some pretty high expenses, reflecting their complex trading strategies.

Rekenthaler: Yes. I’m not a big market-neutral fan, but I think we’ll see more of the funds.

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Times: Do you expect fund companies to impose more redemption fees to keep shareholders in place longer?

Rekenthaler: So far, people have stayed in place pretty well. But if the downdraft goes on for a while, perhaps culminating in a wave of redemptions, that would change many things, and more redemption fees would be just one item. We’re not there yet, however, and I’m not predicting it will happen.

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Times: Do you think fund expenses are likely to compress with expected returns?

Rekenthaler: No. Investors don’t suddenly embrace funds with lower expenses. Even in specific cases where a fund’s fees decline, it takes a while for competitors to adjust their expenses, if at all. There certainly is a small core of investors who are very cost-conscious. But outside of that core, people don’t pay a lot of attention to costs. Even on the Morningstar Web site, where we attract a fairly knowledgeable group, we get many responses from people who defend high-cost funds.

Except for Vanguard, not a lot of money flows to low-cost funds, so there isn’t an economic incentive to offer them. Even if a fund doubled its expenses, it wouldn’t see its sales fall in half; maybe sales would drop 10%. Only if we slog through a weak market for two or three years, and see a lot of articles saying how the fund companies are making more money than investors, might we may see pressure to lower fees. But investors won’t change their attitudes about fund expenses in two months.

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Times: Morningstar, in its Fund Investor newsletter, compiles a bear market rank for hundreds of funds. What’s that all about, and did it accurately predict how funds would behave in the recent downturn?

Rekenthaler: The rank evaluates each fund’s performance in past declines during the ‘90s by looking at performance during down months or clusters of down months--what we define as bearish periods even though they’re not necessarily drops of 20%. We look at relative performance during these off periods, comparing one fund against others.

The measure has worked pretty well [in foreshadowing recent performance]. For example, large-cap funds are expected to post better bear-market returns than small-cap portfolios, according to past results, and that held true in August.

Also, bonds are expected to hold up better than stocks, which also was true. In general, those funds with the worst bear-market scores--the aggressive growth, small-company growth and emerging-markets funds--surely did plunge. The ones with the best scores, especially balanced and conservative blue-chip funds, fared reasonably well.

Yet there have been exceptions. For example, Vanguard Windsor, which scored about average in past bearish periods, was disappointing in August, dropping about 20% for the month. Many other value funds also fared badly in August.

Many people think funds pursuing the value style of investing [which focuses on finding stocks trading at low price-earnings, low price-book ratios and other “bargain” yardsticks] will resist a downturn better than growth funds. Maybe two-thirds of the time, that’s true. But when you have a downturn that’s sparked by fears of recession rather than rising interest rates, then value investors can get hurt because they own a lot of economically sensitive, financially weak companies.

That’s what happened in the third quarter of 1990, when Windsor also performed poorly. August looked much like the third quarter of 1990. The magnitude of decline was nearly the same, as was the behavior of many funds. It’s perhaps notable that in the fourth quarter of 1990, funds holding small growth stocks took off and roared throughout 1991.

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Times: With so many mutual funds available, the investing process has never seemed so overwhelming. Any general tips on how to simplify it?

Rekenthaler: Morningstar’s star system is one way to simplify the process. So are our style boxes [which classify funds according to their portfolio characteristics]. My preference is to pick funds by looking at our category ratings. This is a risk-return measure of each fund against its narrow peer group--similar types of portfolios. So if you find a fund with a high category rating and low expenses, you’re probably in good shape.

I will concede, however, that this quick description doesn’t address the question of what category of fund you should buy--balanced, large value or whatever. If you own three funds already, what should the fourth one be? We don’t have simple answers for that, and I don’t know who does. But compared to the star ratings, which tell what worked well in the past from a broad perspective, I prefer the category ratings as a selection tool.

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Times: Many investors, of course, pay close attention to a fund’s star rating. Yet most funds will see their ratings change over time, which means their perceived attractiveness will change. Are we likely to see a broad shuffling of star ratings following the sharp decline that we’ve had? Will it be a musical-chairs situation in which most funds wind up with a different star rating when the music stops?

Rekenthaler: You see a musical-chairs effect after there has been a big switch in relative performance. If all funds went down 20% for the month, no ratings would change. But after August, balanced funds and other conservative choices clearly are going to start looking good.

Yet the performance spread wasn’t so large for funds that stayed primarily in stocks. Most were down somewhere between 13% and 20%, regardless of whether they held large stocks, small stocks or international companies. So yes, we’ll see more star-rating changes in August than in a typical month, but it won’t be a huge revision.