Why We Downgraded These 5 Funds

Christine Benz: Hi, I'm Christine Benz from Morningstar. We devote a lot of attention to mutual funds that have received upgrades in their Medalist ratings, but we spend a little bit less time on the downgrades. Joining me to shed some light on some mutual funds that have recently been downgraded and what investors can take away from the downgrades is Russ Kinnel. He's Morningstar's director of manager research.

Russ, thank you so much for being here.

Russ Kinnel: Glad to be here.

Benz: Russ, let's talk about, generally speaking, some of the things that tend to trigger downgrades in Medalist ratings. What are the catalysts, typically?

Kinnel: Well, the most obvious one is a manager change. If you have really experienced manager who is key to our thesis and that manager leaves, that may well trigger a downgrade. Another one that's a little more subtle, and there isn't exactly an obvious trigger, is sometimes our conviction just erodes that over time, maybe we look close-- more closely--and and think, well, maybe our thesis isn't as strong or maybe it's simply a matter of performance not living up to, to what we had expected. Other times it can be rising fees, or even fees that don't move down simply because the rest of the industry is getting cheaper.

Benz: You mentioned performance, Russ. What kind of checks do you have against analyst sort of just looking at performance and extrapolating that it deserves a downgrade, because it hasn't delivered? How do you kind of check against that impulse?

Kinnel: Right. I think reading too much into recent performance is a mistake that almost every investor makes, including us. And it's something we try to guard against. And we try to work with the analysts. So, we try to look at it from a few different perspectives. One is long-term, we know that any active fund is going to have a one- or three-year downturn, even most passive funds for that matter, but active more dramatically. So, it's better to look at the longer record, but also to kind of, part of our thesis should be what kind of environment should this fund do well in? What kind of shouldn't do well in? And that should help to guide us.And is this really a change? Is this really failing to meet our expectations? So obviously, a more cautious fund, if it loses more the next two down markets, then that's going to worry us. So that kind of behavior. Or maybe it's a deep value fund. Deep value has a big rally, and it still doesn't do well. So those are the kinds of things we look for. So, it's not simply this fund has had a bad three years. We want to understand that context and want to understand the long-term record as well.

Benz: So let's go through some of the examples of funds that have recently been downgraded, starting with what you said is sort of an obvious catalyst for downgrades, which would be a manager change. This fund that recently saw a downgrade was T. Rowe Price Global Technology, manager change, talented manager moving on to another fund. Let's talk about the story there.

Kinnel: This was one of those moves where one manager leaves the firm, and you see a couple other moves triggered by that. In this case, Henry Ellenbogen left T. Rowe Price New Horizons. T. Rowe then promoted Josh Spencer from their global tech fund to the New Horizons fund. And at global tech, they promoted Alan Tu, who was an analyst in the tech area, but not one with management experience. So, in this case, you have a significant change with Josh Spencer, who had a very good record at the global tech fund moving on, and then Alan Tu with no record taking over. Obviously, there are still some strengths at T. Rowe, but we lowered the fund down to Neutral because you do have a new manager, and that really changes things.

Benz: Let's talk about an issue that you didn't discuss at the outset of the conversation: fees, and the role of fees in determining ratings. There were several several DFA funds that recently saw downgrades in part because even though fees look reasonable in absolute terms, you feel like they're really not keeping pace with some of their competitors. Let's talk about that.

Kinnel: So, fees are a huge component of our analyst ratings, because fees are the best predictor of future performance. And in a way, it's related to the performance discussion we had earlier, in that it's very easy for people to say, well, if this fund performed really well and overcame its high fee in the past, then it must be okay. So who cares about fees? But in fact, we know that, strong-performing funds in the past with high fees don't do so well. Now, the DFA case is more subtle. Here, they actually have relatively lower fees than most of their peers. But what's been going on in the industry is fees have been coming down. Active funds have cut fees, passive funds have cut fees. DFA views itself rightly as kind of in between active and passive. They don't track indexes. And they do have some modest tilts to their portfolios, but in other ways, they're kind of passive. They're not picking stocks, they have very diffuse portfolios, and they're priced accordingly kind of in between. But as the rest of the industry has cut fees, DFA has really stood pat. And so as a result, we've lowered a number of their funds from Silver to Bronze, because we think a little of that edge has gone away.

Benz: So, a couple of the funds on the list would be DFA U.S. Micro Cap and DFA U.S. Targeted Value.

Kinnel: That's right.

Benz: Let's talk about a couple of funds that you think kind of exemplify the "loss of conviction" story. This is PIMCO All Asset All Authority as well as PIMCO All Asset, Rob Arnott's well-known go-anywhere funds. Why have convictions diminished a little bit in these two?

Kinnel: Right, as you mentioned, Rob Arnott, who was just on your podcast, is a very thoughtful investor who's done some really interesting research in a variety of areas. But these are funds that you're really hiring for their allocation for some of their tactical moves. And we certainly understand that no one is going to get all of those right. But his two funds have consistently tilted the last decade toward emerging markets and towards value. And both of those tilts have been wrong over a decade. So that's obviously a pretty long time to be wrong. The All Authority fund we lowered all the way to Neutral, the All Asset to Silver. All Asset has more guardrails, All Authority has wider authority it hasn't used that well. It even has the ability to short and has at times been short the U.S. market, which has been a particularly bad move. So, we still think there are some merits, particularly to All Asset, but over time eventually you have to say, well, these moves haven't worked.