It's probably time for mutual-fund investors to move away from small- and mid-caps and into large-caps -- that's the advice from Standard & Poor's, as delivered by Philip Edwards, S&P's managing director of funds research. The economy is in the second year of a recovery, Edwards points out, and that's when large-cap stocks tend to outperform.
In the last year, however, funds that focus on small-caps have done especially well, says Edwards, citing a 31% climb for the average small-cap value fund. But beyond near-term performance, in choosing a fund he would focus on performance over five years and on such factors as the manager's experience and the fund's expense ratio. One fund he singles out as satisfying those standards is Growth Fund of America (AGTHX ).
With interest rates on the rise, investors in bond funds should stick to the short term, Edwards adds. He mentions the T. Rowe Price Short Term Bond Fund (PRWBX ) and Payden Short Bond Fund (PYSBX ).
These were a few of the points Edwards made in an investing chat presented June 29 by BusinessWeek Online and Standard & Poor's on America Online in response to questions from the audience and from BW Online's Jack Dierdorff. Edited excerpts follow. A full transcript is available from BW Online on AOL, at keyword: BW Talk.
Q: Phil, broadly speaking, have mutual funds been tracking the market?
A:Mutual funds, over the last year, have been doing very well. In many cases, they've actually been beating their benchmarks. Managers have been able to successfully take advantage of the favorable market conditions.
Q: What kind of funds have been doing best recently?
A:Over the last year, all categories of domestic equity funds have done well. But the funds that focus on small-cap stocks have done especially well. For example, the average small-cap value fund over the last year is up 31%. However, I wouldn't necessarily chase performance.
Q: I'm a new teacher, age 34, and setting up my annuities. Are there any I should look at?
A:I think it's important to have a diversified portfolio. As a result, I would look at a combination of U.S. equity funds and international funds and some fixed-income funds to start your portfolio.
Q: In a $300,000 portfolio invested in mutual funds, how many funds are too many?
A:I think that an array of somewhere between 9 and 12 funds is appropriate. Again, they should be diversified across different asset classes to provide the diversity.
Q: What percentage combination of fund types should I set up?
A:The combination that's appropriate is specific for an individual. However, a general midrange portfolio would be about 60% equity and 40% fixed income. Within the equity, the largest part would be funds that focus on large-cap U.S. stocks. And within the fixed income, the largest part should be currently focused on a short-term (one to three years) bond fund. The portfolio should include some cash for liquidity purposes.
Q: I'm 77 -- how would you recommend I split my liquid assets among fixed income and equities?
A:Well, again, it depends on your individual circumstances. And since I don't know much about you, I can't speak to your individual needs. However, S&P's most conservative strategy has only about 15% allocated to funds that focus on large-cap stocks and the remainder focused on fixed income. Within the fixed income, the vast majority is focused on short-term and cash.
Q: A few minutes ago you said you wouldn't necessarily chase performance. What criteria do you prefer?
A:I would ensure the fund has provided consistently strong performance for at least five years. I would also look to see that the same team has managed the product for at least three years and that this team has deep experience. I would look at the expense ratio to make sure that it's competitive with its peers. And I would make sure that the style of the fund is compatible with your investment needs.
Q: Can you name any funds that S&P considers come up to these standards?
A:One fund that we feel very strongly about is Growth Fund of America (AGTHX ). This fund is managed by a very experienced team and has an outstanding track record. The asset size is large but has not been hampering performance.
Q: You mentioned bond funds -- how have they been doing? And what are the prospects, with an interest-rate hike?
A:Excellent question. Interest rates are most likely to head up in the near term. Traditionally, in a rising-interest-rate environment, bond fund prices fall. That's likely to happen again as interest rates rise through the end of the year and potentially next year.
As a result, S&P is suggesting an investor's fixed-income exposure be primarily in funds that focus on shorter-term securities to mitigate the effect of the rising interest rates. An example is Pimco Low Duration A (PTLAX ).
Q: Please explain why Ginnie Mae funds are doing so poorly -- will they do better?
A:Ginnie Mae funds are securities backed by mortgages (typically residential mortgages). Mortgage rates have been trending up in anticipation of the Fed rate increases. As a result, the value of these funds has been dropping.
Q: When inflation is a worry, some investors turn to gold -- what about gold funds?
A:Gold funds have done extremely well in 2002 and 2003, posting annual gains of more than 60%. However, year-to-date, these funds have lost 18%. As you can see, these funds can be very volatile. They can be an effective defensive hedge, but they need to be watched very carefully and profits taken as the opportunity arises to make money in this area.
Q: Are we out of the mutual-fund scandals? There was a recent announcement that funds should have outside boards of directors.
A:I think the mutual-fund scandals are coming to a close. We're likely to hear about some more settlements. But I do think the worst is behind us. I don't think having independent boards of directors will make a significant difference.
Q: We own Fidelity Dividend Growth (FDGFX ), Fidelity Low-Priced Stock (FLPSX ), Janus Fund (JANSX ), and Janus Twenty (JAVLX ). Do you have an opinion on these funds?
A:The Fidelity Low-Priced Stock Fund is one that I would shy away from because of its enormous asset size. Its track record is amazing, but I wonder if it could continue, given its weight. Fidelity Dividend Growth has had a good long-term track record, but its shorter-term performance has suffered. It has had the same management since 1977. And its expenses are very competitive. So it sounds like a reasonable fund.
The Janus Fund's performance has been poor for quite a while now. There has been a lot of disruption within Janus. But its expenses are very competitive. I would consider this fund to be below average. After suffering for an extended period, the Janus Twenty Fund has come back to life, benefiting from the strong rebound in the market in 2003. Through the first five months of this year, it has done exceptionally well. If you're prepared for the volatility in this fund and believe that the market is positioned to have fairly robust growth, this might be a good place to be.
Q: Thoughts on Janus Worldwide fund (JAWWX )?
A:This fund has been especially bad since 2000 and has recently experienced some management turnover. It's a fairly aggressive fund. It's one I would stay away from.
Q: What do you think of Target Large Cap Growth (TALGX ) and Large Cap Value (TALVX )?
A:The TALGX portfolio is the definition of mediocrity. The performance track record has been average. The investment team has been associated with the fund for an extended period, which is good. However, the risk with this fund is relatively high compared with its returns. As a result, I don't think the risk-return ratio is beneficial.
Now, the Value Fund, on the other hand, is very good. It has demonstrated a consistently strong track record, with risk-return very near the peer group. As a result, I think this could be a very good fund.
Q: Over the next 18 months, how do you weight international vs. domestic investments?
A:S&P thinks there are strong relative opportunities in the international markets. As a result, S&P has been increasing its allocation to international funds. The amount an individual should be exposed depends on their unique circumstances, but generally, no more than 15%.
Q: What are some of the international funds you rank high?
A:Julius Baer International Equity (BJBIX ) is a very strong fund, as well as Thornburg International Value (TGVAX ).
Q: Did tech funds flourish in 2003 as tech recovered -- and what has happened so far this year?
A:Technology, yes, was the strongest sector in 2003, increasing 47%. Year-to-date, the sector has lost 2%. However, S&P's analysts feel it has room for continued growth. As a result, this may be a sector worth looking at.... One group we're impressed with is ICON, and they run a number of different sector funds, including technology.
Q: Small-cap vs. mid-cap vs. large-cap funds -- what looks best now?
A:Small- and mid-cap funds have had a really strong run. Typically, in the second year of a recovery, which we're currently in, large-caps outperform small- and mid-caps. As a result, S&P is suggesting that investors increase their exposure to large-caps at the expense of small- and mid-caps.
Q: Your opinion on Washington Mutual Investors fund (AWSHX ) and Franklin Income (FKINX )?
A:Washington Mutual Investors is managed by a team of experienced professionals and is a very strong fund. However, the pool of stocks from which the managers can choose is very limited by prospectus. That would be my only hesitation with this product.
FKINX has demonstrated some stellar performance, consistently ranking near the top of its peer group since 2000. This fund has had a management team in place for an extended period of time. It looks like a keeper.
Q: Your opinion, please, on ING Global Science & Technology (ATNAX ) and IDEX PBHG Mid Cap Growth (IMCBX )?
A:ATNAX has done about as well as its peers over the last three years. It appears to be a well-diversified fund with fairly low turnover. Overall, it's average. IMCBX is run by Pilgrim Baxter. And given its problems with insider trading, I would stay away from this fund.
Q: What's the pick for fixed income over 5% with growth potential?
A:It's tough to identify any fixed-income fund with growth potential, given the likelihood of interest rate increases over the next 24 months. However, there are some very good short-term bond funds, such as T. Rowe Price Short Term Bond Fund (PRWBX ) and Payden Short Bond Fund (PYSBX ).
Edited by Jack Dierdorff