Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Mutual fund investors have seen volatility in both their stock and bond portfolios so far in 2018. Joining me to provide a midyear recap of the action in mutual funds is Russ Kinnel. He is director of manager research for Morningstar.
Russ, thank you so much for being here.
Russ Kinnel: Glad to be here.
Benz: Russ, let's start by talking about bonds, because even though we have a few days to go here in the first half of 2018, it does seem that some of the losses that mutual fund investors have experienced have been concentrated in their bond holdings. First, what's going on in the bond world that has led to losses in bond funds?
Kinnel: We are seeing signs of rising inflation and the Fed is responding by raising rates. And so, we are seeing the long end of the bond world sell off in anticipation of more rate hikes and possibly more inflation. We have talked about the smooth ride in equities. It's even smoother in fixed income and we have barely noticed any bumps since '08. And so, it hasn't been a disaster, but a lot of bond funds are in the red this year.
Benz: In terms of the types of bond funds that have gotten hit the hardest so far in 2018, where have those losses been concentrated? You mentioned long-term has been the hardest hit spot?
Kinnel: That's right. So, if you have a long end, like a Treasury fund or a lot of muni funds are longer term, those may be down 1% or 2% this year. They are maybe doing the worst. Emerging-market bonds have also done poorly.
Benz: In terms of the types of bond funds that have held up relatively better, can you talk about those?
Kinnel: Yes. Naturally, they are at the other end of the yield curve. So, bank-loan funds, which ratchet up their rates as interest rates rise and therefore, aren't really affected by rising rates, those are doing the best. Then ultrashort bonds and short-term bonds, because obviously they have very little interest-rate exposure. And then sort of in between the good and the bad is intermediate-term bonds, which have lost more than them. They are in the red about 1.5% as we speak, but we've got a couple of days left in the month.
Benz: If investors are looking at their bond holdings, how should they be approaching them? I think some investors are very fearful about what might be next for the bond market.
Kinnel: Right. Obviously, bonds are your more conservative investment, maybe a place you go to if you need emergency cash. But I do think you should have a plan that allows for these kinds of blips. I mean, we are talking about for the most part funds that are down 1% or 2%. That's really minor. That's a regular occurrence. You certainly shouldn't be surprised by that and it shouldn't be something that upsets your plan. I think, for sure, it signals that there could be some more headaches along the way and you have to have a robust plan. I think it makes sense to be diversified, makes sense to be aware of what kind of credit risk you have, because credit risk is something that for the last few years has done really well, but every once in a while, it blows up. You want to understand your plan, but you should be able to handle these minor blows to the markets.
Benz: Maybe be careful about taking crazy amounts of duration risk, too, because you mentioned that that part of the bond market has been hardest hit most recently.
Kinnel: That's right. Every once in a while, duration risk, so long-term bonds get hit hard because inflation or interest rates spike. And so, you want to be prepared for that. Diversify not just by credit risk but also by places on the yield curve. Have some short and intermediate exposure, too.
Benz: Let's talk about equities, because equities did experience some volatility earlier in the year, like, back in February. That seemed mainly sort of inflation-, interest-rate related. More recently, some of these tariff concerns have roiled stocks. What's going on in the equity market and which types of funds have been hardest hit by some of the volatility that we have seen?
Kinnel: Yeah, you are right, we have had a few ups and downs, both individual company issues as well as some big market issues. Of course, the trade dynamics seem to change every day and therefore, that's part of why it's so volatile as that's changing. Even if you, say, had a set deal on tariffs today, obviously, it takes a while for the markets to really figure out what does that mean for all these individual companies. The companies that are more affected by these trade wars are definitely the ones whose share prices are hit harder.
Benz: One thing we've seen so far in 2018 has been the outperformance of growth stocks at the expense of value investing. This is something that's been going on for a while. What's going on there in general and how has this affected mutual fund performance?
Kinnel: You are right. Tech and healthcare are really dominant. And a part of the story is just the FAANGs continuing to be so strong. The FAANGs are Facebook, Amazon, Apple, Netflix, Google. They are doing really well and part of what they are doing well at the stake of some value names--you think of like retail, newspaper, some others--they are essentially taking business away from the value side, and that's still showing up. I am sure at some point it reverses, but once again, large value is the worst place to be. Small growth is the best place. For the year to date, small growth sort of catching up with large growth. And so, if you see, smaller-cap tech and healthcare names have really done well.
Benz: Equity investors might look at this and say, well, value has underperformed for so long, potentially, is it a place for me to be looking if I'm adding to holdings in my equity portfolio? What's your counsel there in terms of how investors should approach that value versus growth split in their portfolios?
Kinnel: Generally, you want to be relatively neutral. I am not so picky that I think you have to be perfectly split down the middle, but I think you generally want to avoid a big overweight. If say, your growth funds have really had a big ride, it probably makes sense to rebalance into some value. But to say, what does mean for the next six months or a year or two years, really hard to say. There's no reason growth couldn't continue to outperform. That's too hard to predict the short-term moves.
Benz: Then moving over to international equity funds, let's talk about what's been going on there. And you mentioned we still have a few days left in the quarter until July 1. But when investors look at their equity fund holdings right now, they are seeing some red ink. What's going on in terms of performance?
Kinnel: That's right. So, rising U.S. interest rates once again are a big deal for these overseas equities. One reason is, emerging markets are very sensitive to U.S. interest rates and dollar strength. That's hurting them. Also, you see, obviously, the trade wars affecting a lot of the markets. Then there are some individual countries, Turkey and Argentina are maybe the worst off, where they are having their own significant problems. You have got all that going on. There's some wariness of European banks and financials. And then, again, the dollar strength also means that your foreign equity holdings probably don't look so good because most foreign equity funds do not hedge their exposure. A rising dollar means you are doing worse than the actual markets themselves.
Benz: In currency-adjusted terms?
Kinnel: Right. So, that's one reason that your typical foreign fund has done worse than your typical domestic fund.
Benz: When I look down the line at different foreign equity funds, one thing I seem to see is that some of the riskier types of products have been hit a little worse. You mentioned emerging markets, why they have been hit, but it also appears that maybe some of the smaller-cap foreign names have been hit harder. What's going on there?
Kinnel: Yeah, I think you are right. Part of it is something like a risk-off movement where you move out of the riskier plays. Also, I think, again, some of the markets are just affected by the trade wars. Some of the smaller companies, it's really hitting almost random because each country is choosing different trade targets to stab at their rival and really inflict pain, and they can obviously choose anywhere in their rivals' economy. And so, that's hard to predict, but it's really affecting a wide array of companies.
Benz: Russ, thank you so much for being here to provide a midyear recap of the mutual fund market.
Kinnel: You're welcome.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.