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In 2008, anything with a whiff of risk was roundly shunned by investors. Small-cap equities fared poorly, emerging markets bombed, and investors favoured defensives such as consumer staples and health care over cyclicals. While market volatility suggests investors still have reason to be cautious, risk isn't quite the dirty word it was a few short months ago. Backed by firming oil and metals prices, key emerging markets have moved up. Small and mid-caps across the board are faring better on a relative basis. Even junk bonds (euphemistically known as "high-yield") have fared well.
To be clear, we are not suggesting investors have returned to the free-wheeling pre-credit crunch mentality or anything even close to it. However, it does appear that they are finding enough value in certain areas to take on incrementally more risk than was the case in 2008.
Sector Fund Performance: Gold glitters, tech and cyclicals strong; financials, property slump
The Morningstar Sector Equity: Precious Metals category delivered by far the best performance of any sector-specific fund group in 1Q. This largely reflects an increase in gold prices during the period as most funds in the category invest primarily or exclusive in the equities of gold mining companies. Other strong performing Morningstar Sector Equity fund categories included Technology (up 1.6%), Industrial Materials (down 0.3%), and Energy (down 3.6%). Conversely, two defensive areas underperformed: the average health care fund lost 7.4%, whilst the average Consumer Goods & Service Fund fell 9.2%. But if investors were ready to take on some additional risk, they still avoided areas at the centre of the credit crunch: The worst performing Morningstar Sector Equity fund categories in 1Q were Real Estate: Indirect, Financial Services, and Real Estate: Indirect - Europe. Funds in these categories lost 20.4%, 18.7%, and 17.3% on average.
| Morningstar Category | Total Ret 3 Mo (Qtr-End) GBP | Total Ret 3 Mo (Qtr-End) EUR | Total Ret 3 Mo (Qtr-End) USD | Total Ret 3 Mo (Qtr-End) JPY |
|---|---|---|---|---|
| Sector Equity Precious Metals | 13.30 | 18.26 | 12.96 | 23.07 |
| Sector Equity Technology | 1.62 | 6.06 | 1.31 | 10.38 |
| Sector Equity Industrial Materials | -0.25 | 4.11 | -0.56 | 8.35 |
| Sector Equity Biotechnology | -3.39 | 0.84 | -3.69 | 4.94 |
| Sector Equity Real Estate Direct - Germany | -3.46 | 0.76 | -3.76 | 4.86 |
| Sector Equity Energy | -3.57 | 0.65 | -3.87 | 4.74 |
| Sector Equity Real Estate Direct | -5.52 | -1.39 | -5.81 | 2.62 |
| Sector Equity Health Care | -7.35 | -3.30 | -7.64 | 0.64 |
| Sector Equity Other | -7.99 | -3.96 | -8.27 | -0.05 |
| Sector Equity Communications | -8.73 | -4.74 | -9.01 | -0.86 |
| Sector Equity Consumer Goods and Services | -9.24 | -5.27 | -9.52 | -1.42 |
| Sector Equity Real Estate Indirect - Asia | -10.05 | -6.11 | -10.32 | -2.29 |
| Sector Equity Utilities | -14.26 | -10.51 | -14.52 | -6.86 |
| Sector Equity Real Estate Indirect - Europe | -17.29 | -13.67 | -17.54 | -10.16 |
| Sector Equity Financial Services | -18.67 | -15.11 | -18.92 | -11.66 |
| Sector Equity Real Estate Indirect | -20.43 | -16.95 | -20.68 | -13.57 |  |
Select Emerging Markets Rebound: Russia, Latin America show strength
The sector trends in the quarter are highly evident in the performance of funds focussed on different regions. This is especially true in emerging markets, which saw Russia and Latin America funds deliver strong returns. The average fund in the Morningstar Russia Equity category returned 8.8% and held a near-60% combined stake in energy and industrial materials (the latter is in this case mostly made up of metals and mining issues). Similarly, the average fund in the Morningstar Latin America Equity category rose 3.5% in the period and held just over 30% combined in energy and industrial materials.
| Morningstar Category | Total Ret 3 Mo (Qtr-End) GBP | Total Ret 3 Mo (Qtr-End) EUR | Total Ret 3 Mo (Qtr-End) USD | Total Ret 3 Mo (Qtr-End) JPY |
|---|---|---|---|---|
| Russia Equity | 8.79 | 13.55 | 8.45 | 18.17 |
| Taiwan Small/Mid-Cap Equity | 7.89 | 12.61 | 7.56 | 17.19 |
| Taiwan Large-Cap Equity | 7.37 | 12.07 | 7.05 | 16.63 |
| China Equity | 5.26 | 9.87 | 4.94 | 14.34 |
| Latin America Equity | 3.45 | 7.98 | 3.13 | 12.37 |
| Greater China Equity | 2.33 | 6.80 | 2.01 | 11.15 |
| Emerging Markets Equity | -1.37 | 2.94 | -1.67 | 7.13 |
| Hong Kong Equity | -1.99 | 2.30 | -2.29 | 6.46 |
| ASEAN Equity | -4.42 | -0.24 | -4.71 | 3.82 |
| Malaysia Equity | -4.70 | -0.53 | -4.99 | 3.52 |
| India Equity | -5.89 | -1.77 | -6.18 | 2.23 |
| Emerging Europe Equity | -7.87 | -3.84 | -8.16 | 0.07 |
| Emerging Europe ex-Russia Equity | -16.85 | -13.21 | -17.11 | -9.68 | |
The remainder of emerging Europe didn't fare nearly as well. Indeed, the average fund in the Morningstar Emerging Europe ex Russia category lost 16.9%, reflecting investor concern over risks in these smaller markets. China funds rose, with the average fund in the Morningstar China equity sector gaining 5.3% in the period on the back of a strong stimulus package, whilst India funds fell an average of 5.9% given a lack of stimulus and investor concerns regarding upcoming elections in the country.
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UK Equity: Small cap funds show resilience, finally . . .
UK equity funds largely reflected broader market trends in 1Q. Most notably, funds orientated to small- and mid-cap issues outperformed those focussed on larger-cap issues, while growth outperformed value (most equity-income funds land in value) in the large-cap arena. The UK Small-Cap Equity category lost just 1.98% in the period, better than all other developed Europe equity categories save Norway Equity.
| Morningstar Category | Total Ret 3 Mo (Qtr-End) GBP | Total Ret 3 Mo (Qtr-End) EUR | Total Ret 3 Mo (Qtr-End) USD | Total Ret 3 Mo (Qtr-End) JPY |
|---|---|---|---|---|
| UK Small-Cap Equity | -1.98 | 2.30 | -2.28 | 6.47 |
| UK Mid-Cap Equity | -6.68 | -2.60 | -6.96 | 1.37 |
| UK Large-Cap Growth Equity | -8.01 | -3.99 | -8.29 | -0.08 |
| UK Large-Cap Blend Equity | -9.07 | -5.09 | -9.35 | -1.23 |
| UK Large-Cap Value Equity | -10.84 | -6.94 | -11.12 | -3.16 | |
This in part reflects the economic exposures of the market-cap ranges in the UK equity market: Small-cap and mid-cap funds have little to no exposure to the struggling banks sector. While they do have financials exposure, Morningstar holdings data shows that it comes primarily via insurers and capital markets issues, which have been more resilient than banks. UK small- and mid-cap funds also have little pharmaceutical exposure compared to their large-cap peers, which would have been a plus as drug giants such as GlaxoSmithKline and AstraZeneca sank sharply in 1Q. The average small-cap fund also has more exposure to technology issues--one of the strong performing areas of the market in 2009--than the typical mid- or large-cap fund.
The strength of funds further down the cap scale may well also owe something to bottom-fishing by investors--the typical UK Small-Cap Equity fund lost 48.4% from 5 June 2007 through the end of 2008. To give some perspective, that was the largest loss suffered by any of the 165 Morningstar fund categories in the period. The next biggest losses were suffered by Russia Equity funds (down 47.5%) and Austria Equity funds (down 45.1%).
Across the large-cap style spectrum, growth's edge over value owes to two factors: First, value managers in general will tend to own more companies that are out of favour in the market. That in itself isn't bad, but in this environment it can mean they have more exposure to capital-constrained or otherwise struggling issues than their growth brethren. Second, value funds also had slightly more exposure to financials and less to stronger areas such as mining and energy according to Morningstar data--factors that would have worked against them in 1Q.
Among the 10 largest UK equity funds, performance was generally poor in the quarter. Most notably, Neil Woodford's Invesco Perpetual High Income and Invesco Perpetual Income funds posted losses in excess of their Morningstar category averages and the FTSE All Share index. Both funds have an orientation towards consumer and defensive issues, which would have held them back in the period on a relative basis. At the other end of the scale, Fidelity Special Situations delivered a strong showing under Sanjeev Shah, despite a significant overweight in financial services issues, and M&G Recovery delivered a strong outing under Tom Dobell, fuelled in part by energy issues and an underweight in financial services.
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European Regional Equity: Small caps in favour
The trend for small-caps to hold up better than large-caps held true in Europe as well in the UK. In both the Europe ex-UK and pan-European equity category groups, small- and mid-cap categories outperformed large-cap categories. The reasons are similar to those in the UK--namely, big cap banks, where these funds had little if any exposure, fared poorly. They also had little exposure to struggling large-cap pharmaceutical, utility, and consumer staples issues and were coming from a low base after a terrible performance through the credit-crunch.
| Morningstar Category | Total Ret 3 Mo (Qtr-End) GBP | Total Ret 3 Mo (Qtr-End) EUR | Total Ret 3 Mo (Qtr-End) USD | Total Ret 3 Mo (Qtr-End) JPY |
|---|---|---|---|---|
| Europe Small-Cap Equity | -9.14 | -5.16 | -9.42 | -1.30 |
| Eurozone Small-Cap Equity | -9.59 | -5.64 | -9.87 | -1.80 |
| Eurozone Single Country Equity | -10.34 | -6.42 | -10.61 | -2.61 |
| Europe Mid-Cap Equity | -10.71 | -6.80 | -10.98 | -3.01 |
| Europe Large-Cap Growth Equity | -11.41 | -7.53 | -11.68 | -3.77 |
| Eurozone Mid-Cap Equity | -13.15 | -9.35 | -13.42 | -5.66 |
| Europe Large-Cap Blend Equity | -13.40 | -9.61 | -13.67 | -5.93 |
| Europe Large-Cap Value Equity | -14.70 | -10.97 | -14.97 | -7.35 |
| Europe ex-UK Equity Large Cap | -14.85 | -11.12 | -15.11 | -7.50 |
| Eurozone Large-Cap Equity | -16.42 | -12.76 | -16.68 | -9.21 | |
Norway Equity: Powered by a comeback in energy
The Morningstar Norway Equity category was the strongest developed Europe category in 1Q 2009, rising 4.35%. Funds in the category benefited immensely from the energy rally: The sector constitutes 50% of prominent local market indices and StatoilHydro typically accounts for 30% of broad indices on the Norwegian market. Such concentration can cut both ways, however. One of the Norwegian market’s key stocks, Telenor, was hit by problems in its Russian operation, demonstrating the stock-specific risk that investors face in the country.
The average fund in the Norway Equity category lagged the OBX, OSEBX and OSEFX indices, which are the most prominent benchmarks in the Norwegian market. These indices had returns of 6.4%, 4.4% and 3.5% respectively. The average fund in the category devoted 46% of equities to the energy sector at the end of February. Energy provided a return of 3.4 % in NOK terms. In a sharp break from other European markets, financials provided a positive return of 8.6% in NOK terms. The average Norway Equity fund holds 7% of its equity exposure in the sector.
Industrials, materials and telecoms all dragged on returns, with the average Norway Equity fund holding 13.8%, 12.5% and 6% of equities in these sectors respectively. Industrials fell 7% in NOK terms, materials lost 4.5% in NOK and telecom services dropped 16.7 % in NOK from year end through 31 March.
| Morningstar Category | Total Ret 3 Mo (Qtr-End) GBP | Total Ret 3 Mo (Qtr-End) EUR | Total Ret 3 Mo (Qtr-End) USD | Total Ret 3 Mo (Qtr-End) JPY |
|---|---|---|---|---|
| Russia Equity | 8.79 | 13.55 | 8.45 | 18.17 |
| Norway Equity | 4.35 | 8.92 | 4.03 | 13.35 |
| UK Small-Cap Equity | -1.98 | 2.30 | -2.28 | 6.47 |
| Sweden Small/Mid-Cap Equity | -3.56 | 0.66 | -3.86 | 4.75 |
| UK Mid-Cap Equity | -6.68 | -2.60 | -6.96 | 1.37 |
| Portugal Equity | -7.14 | -3.08 | -7.43 | 0.87 |
| Sweden Large-Cap Equity | -7.39 | -3.34 | -7.67 | 0.60 |
| UK Large-Cap Growth Equity | -8.01 | -3.99 | -8.29 | -0.08 |
| France Small/Mid-Cap Equity | -8.97 | -4.98 | -9.25 | -1.12 |
| UK Large-Cap Blend Equity | -9.07 | -5.09 | -9.35 | -1.23 |
| Austria Equity | -9.14 | -5.16 | -9.42 | -1.30 |
| Belgium Equity | -10.49 | -6.57 | -10.76 | -2.77 |
| Finland Equity | -10.74 | -6.83 | -11.01 | -3.04 |
| UK Large-Cap Value Equity | -10.84 | -6.94 | -11.12 | -3.16 |
| Denmark Equity | -12.39 | -8.56 | -12.66 | -4.84 |
| Netherlands Equity | -14.31 | -10.57 | -14.58 | -6.92 |
| Germany Small/Mid-Cap Equity | -14.47 | -10.73 | -14.74 | -7.10 |
| France Large-Cap Equity | -15.07 | -11.36 | -15.33 | -7.75 |
| Switzerland Small/Mid-Cap Equity | -15.43 | -11.73 | -15.69 | -8.14 |
| Switzerland Large-Cap Equity | -15.44 | -11.75 | -15.70 | -8.15 |
| Italy Equity | -16.15 | -12.48 | -16.41 | -8.92 |
| Spain Equity | -16.92 | -13.29 | -17.18 | -9.76 |
| Germany-Large Cap Equity | -19.16 | -15.62 | -19.41 | -12.19 | |
German Equity: Lack of resource issues, cyclical bias hit German Equity funds hard
At the other end of the European spectrum, industrial cyclical exposure and a lack of energy and mining issues dragged down German large caps relative to European peers, causing Morningstar’s Germany Large Cap Equity category to lose more than 19% in the first quarter--the worst developed Europe performance for the period. Automobile stocks VW, Daimler and BMW were hammered, along with industrial giant Siemens. Prominent German contrarian fund manager Jürgen Meyer holds in his EUR 500 SEB Aktienfonds approx. 25% in automobile stocks. Utility heavyweight EON lost ground in a pretty brutal manner given the defensive role most companies are assumed to play in a portfolio.
Morningstar’s German Small Cap Equity category fared two percentage points better than the broader German Equity category. Most German equity fund offerings following an all-cap approach are already heavily underweight in the small- and mid-cap space. This relative dearth of selling pressure as well as the lack of exposure to utilities and large industrial conglomerates helped give these offerings a slight edge over their large-cap rivals.
Swiss Equity: No longer a safe haven
Morningstar’s Swiss Large Cap Equity category fared poorly, losing nearly 16% as key defensive issues that had worked well in 2008 gave up ground. Swiss equity offerings traditionally show a tilt to defensive sectors like pharma and consumer staples, but in 1Q 2009, issues such as consumer giant Nestlé, and drugmakers Novartis and Roche lost their safe haven status for fund managers and investors. These names appear frequently among the top holdings of European and global equity funds, and are oft praised by fund managers for their defensive cash generating abilities. However, Nestlé, Novartis and Roche are currently showing up as growth or even high growth stocks in the Morningstar style box, indicating that pricing may be overly ambitious for defensive sectors.
Austrian Equity: On the way back?
Austrian stocks showed impressive resilience after heavy losses in 2008. Reflecting this, the average fund in Morningstar’s Austrian Equity category lost just 9.1% for the first quarter. This is somewhat surprising: The Austrian equity market is often viewed by institutional investors as a safer way to play Eastern Europe--but in this case, we note that Eastern Europe ex Russia has fared pretty badly, yet Austrian Equity funds remained relatively stable. This owes in part to the strength of large market constituents such as Telekom Austria, Raiffeisen International Bank Holdings, and energy group OMV. Smaller-cap issues such as property firms Immoeast Immbolien Anlagen and Immofinanz Immbolien Anlagen, and online gaming concern bwin Interactive Entertainment have also rallied sharply from lows, aiding some funds in the category.
France Equity: Small was beautiful, or at least less ugly
Morningstar’s French Large Cap Equity category suffered heavy losses in the first quarter, falling roughly 15%. The losses were in line with the major Paris stock index CAC 40, dragged down by banks like Societe Generale and insurers such as Axa. The French Small & Mid Cap Equity category, which was less exposed to the financials sector, lost only half as much. Fund managers have begun to move away from large caps, at the same time moving to the value side of the Morningstar style box. The smaller-cap tilt led to French large cap funds gaining an average of 3.7% in the month of March, while the CAC 40 lost 7%. In the French Small and Mid Cap category, the best performer was Raymond James Microcap with a positive return of 2.7%.
Italy Equity: The cash-heavy and the financials-light won the first quarter
During the first three months of 2009, the global financial crisis continued to buffet the Italian stock market. On a relative basis, the Italian financial sector performed worse than the overall market as measured by the MSCI Italy, though in the last part of the quarter, the recovery of large banks, such as Unicredit and Intesa Sanpaolo, contributed to reversing this trend. Not surprisingly, given conditions, the best performing funds in the Morningstar Italy Equity category in the first quarter were those that were positioned in a more defensive way: funds that were underweight financials, such as Motus Sicav Italian Equity or Symphonia Azionario Italia Small Cap, and funds with a large component of cash, such as Ducato Geo Ita Alto Potenziale and Vegagest Azionario, were able to limit losses during the market downturn.
Spain Equity: Smaller caps and Telefonica were the places to hide
As was the case across most of Europe, the first quarter was negative for funds in Morningstar’s Spanish Equity category. The average fund in the category suffered a loss of 16.9%. That’s better than the benchmark IBEX 35, which declined more than 13% during the same period. A few interesting insights can be extracted from the analysis of first quarter returns. First, as was the case across most of Europe, funds more heavily invested in small- and mid-caps performed much better than the average. A few good examples are BK Pequeñas Compañías (-3.0%) and Santander Mid Caps Iberia (-3.6%). That is consistent with the comparison between the MSCI Spain NR (-13% for the quarter) and the MSCI Spain Small Cap NR (-10.5%). In the other extreme of the rankings are funds that are still using leverage in their investment policy. Examples include BBVA Bolsa Ibex Quant (-21.3%), Foncaixa Bolsa España 150 (-19.6%) or Santander Aggressive Spain (-19.4%). There is also a tremendous difference in terms of sector returns. As in other countries in Europe, the Spanish banking sector suffered a lot during the first quarter (-21.3%) and top performers had a bit less in financials than did those at the bottom of the league tables. Meanwhile, the telecommunication sector, dominated by Telefonica, proved fairly defensive, falling 5.2% in EUR terms.
Netherlands Equity: A difficult start
The year did not start well for Dutch investors. Funds investing solely in Dutch equities lost an average of 14.3%. As with most markets, energy exposure was a key differentiator in the first quarter. The average energy exposure in the Netherlands Equity Category is 16.7% of assets, with Royal Dutch Shell the largest holding. Some funds have 25-30% of assets in energy, while funds that use the AEX Index as a benchmark has energy positions close to 0%. Not surprisingly, given the energy rebound of 2009, the worst performing funds in the Netherlands Equity Category were index funds offered by Aegon, ING, and Fortis that track the AEX-index.
Market-cap focus has also been an important factor in 2009, with smaller-cap focussed funds outperforming larger-cap focussed funds by a significant margin. This was in part because they had little exposure to battered financials relative to their larger-cap rivals. Dutch funds characterised by the Morningstar Style Box as small- or mid-cap, including Orange Fund, Delta Deelnemingen, Fortis Small Cap and all cap fund Delta Lloyd Nederland, faced lighter losses than their large-cap peers.
Belgium Equity: Financials and telecoms hurt funds
Funds investing in Belgium did a better job than their Dutch counterparts, but also lost money. The Morningstar Belgium Equity category suffered a loss of 10.5% on average with financials and telecoms being the biggest disappointments. Utilities and consumer goods such as Suez and Inbev surprised with gains of more than 20% in the first quarter.
Financial services stocks are still by far the biggest sector for funds in the Belgium Equity Category, but they have lost the glory they once had. For example, one year ago, the three biggest banks on the Belgian market (Fortis, KBC and Dexia) had a total weight in the Bel 20, the index of most important stocks, of 37%. Now they account for only 7.5%. Still, the average fund in the Belgium Equity category has 27% of assets invested in financials with Groupe Bruxelles Lambert the most popular holding, and Fortis the most controversial. Fortis shareholders will vote next month on a new agreement between the Belgian government and BNP Paribas after a third round of negotiations. At this time, however, it remains unclear what will happen with Fortis Investment Management.
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Asian Equity: Surprising bright spots in Taiwan and China
Asia was not immune from the gloomy global economic outlook in the first quarter of 2008, but there was just enough positive news in the area to push the average fund in the broad Morningstar Asia-Pacific ex-Japan Equity category down 0.6%. In contrast, the Asia-Pacific with Japan Equity category lost 7.22%, reflecting the poor performance of Japanese equities, which was accentuated in Europe by the Yen's depreciation relative to the pound and Euro.
| Morningstar Category | Total Ret 3 Mo (Qtr-End) GBP | Total Ret 3 Mo (Qtr-End) EUR | Total Ret 3 Mo (Qtr-End) USD | Total Ret 3 Mo (Qtr-End) JPY |
|---|---|---|---|---|
| Taiwan Small/Mid-Cap Equity | 7.89 | 12.61 | 7.56 | 17.19 |
| Taiwan Large-Cap Equity | 7.37 | 12.07 | 7.05 | 16.63 |
| China Equity | 5.26 | 9.87 | 4.94 | 14.34 |
| Greater China Equity | 2.33 | 6.80 | 2.01 | 11.15 |
| Australia & New Zealand Equity | 0.95 | 5.37 | 0.64 | 9.65 |
| Asia-Pacific ex-Japan Equity | -0.56 | 3.79 | -0.86 | 8.02 |
| Korea Equity | -1.81 | 2.48 | -2.11 | 6.65 |
| Hong Kong Equity | -1.99 | 2.30 | -2.29 | 6.46 |
| ASEAN Equity | -4.42 | -0.24 | -4.71 | 3.82 |
| Malaysia Equity | -4.70 | -0.53 | -4.99 | 3.52 |
| India Equity | -5.89 | -1.77 | -6.18 | 2.23 |
| Asia-Pacific with Japan Equity | -7.22 | -3.16 | -7.51 | 0.78 |
| Singapore Equity | -8.73 | -4.74 | -9.01 | -0.86 |
| Japan Large-Cap Equity | -15.50 | -11.80 | -15.76 | -8.21 |
| Japan Small/Mid-Cap Equity | -16.01 | -12.33 | -16.26 | -8.76 | |
Taiwan proved the most resilient market in the region. Morningstar’s Taiwan Large-cap Equity category gained 7.37%, led by technology stocks, and outran all Asian rivals in the quarter. Although some large tech players, such as TSMC, are still expecting headwinds, they rebounded after big losses in the fourth quarter of 2008. The average fund in the Greater China Equity category rose 2.3%. According to Morningstar’s holding data, the top 20 funds held an average of 33% assets in Taiwanese equities, while the bottom 20 help just 23%. On a sector basis, Greater China equity funds with overweight positions in technology stocks and underweight positions in financials tended to outperform over the first quarter.
In 2009, portfolio managers of broad Asia Pacific Equity funds are paying more attention to Taiwan, Philippines and China, which has also been resilient. Chinese equities, underpinned by the RMB 4 trillion stimulus package, fared better than most Asian and Western peers. Many portfolio managers of Asia Pacific Equity funds have been looking for beneficiaries of the stimulus, such as infrastructure stocks, and these stocks fared well last quarter. On the other hand, many managers have trimmed exposure to Korean and Singaporean equities. Banks in those countries have been hard hit by non performing loans.
US Equity Funds: Value funds slump; growth rules
US Equity fund returns were broadly split by style in the quarter. Specifically, growth issues outperformed value markedly. Investors in US equities are according the greatest favour to large businesses with manageable debt levels, such as wide-moat stalwart Coca-Cola. Technology and Internet-related companies such as Google, Apple and Qualcomm also fared well. They don't have the steady revenues and earnings of Coke, but they have solid balance sheets. All three have equity/asset ratios of 50% or more, suggesting strong financial health.
As elsewhere, financials, including banks and real estate issues, drove down the value indices, as credit remains tight, and firms with debt struggle both to refinance and in some cases to make interest payments.
| Morningstar Category | Total Ret 3 Mo (Qtr-End) GBP | Total Ret 3 Mo (Qtr-End) EUR | Total Ret 3 Mo (Qtr-End) USD | Total Ret 3 Mo (Qtr-End) JPY |
|---|---|---|---|---|
| U.S. Large-Cap Growth Equity | -4.53 | -0.35 | -4.82 | 3.71 |
| U.S. Mid-Cap Equity | -7.41 | -3.36 | -7.70 | 0.57 |
| U.S. Large-Cap Blend Equity | -9.39 | -5.43 | -9.67 | -1.58 |
| U.S. Small-Cap Equity | -11.11 | -7.22 | -11.38 | -3.45 |
| U.S. Large-Cap Value Equity | -12.25 | -8.41 | -12.52 | -4.68 | |
This equity performance was clearly reflected in the Morningstar fund categories: The best performing fund category was US Large-Cap Growth--down 4.5%--reflecting the generally heavier emphasis of these funds on technology issues and lower emphasis on financial services. The strength also owes in part to the notably lower debt-to-cap ratios of the holdings in these funds. Funds in the Large-Cap Value category were the worst performers, falling 12.3% on average. This reflects their larger stakes in financials and willingness to own cheaper, but somewhat more troubled, companies at a time when investors continue to seek certainty. US Small Cap Equity was close behind, falling 11.1% on average--the loss is a marked split from the European trend of small-cap outperformance. We note in this respect that US Small Cap funds have holdings with much lower ROE and ROA figures than their large-cap counterparts, an indicator of quality that may account for their sluggishness in a market where investors remain attuned to risk.
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Bonds: High yield runs ahead
It appears demand for credit-risk has come back, at least to an extent. Whether looking at funds focussed on US dollar, Sterling, or Euro debt, high-yield funds (which focus on below-investment-grade credits) soundly beat all other bond categories in the first quarter. This stood in contrast to broad corporate bond funds, which were the worst performers across the board, dragged down in part by significant exposure to the financials sector. In the case of high-yield, it's worth noting that the default rates implied by yields at their peak were extraordinarily high, as much as 35% in some markets, which would by far eclipse the highest default rate on record. That suggests there was strong value to be had for intrepid investors, and may have inspired bottom fishing by investors, helping spreads to narrow.
| Morningstar Category | Total Ret 3 Mo (Qtr-End) GBP | Total Ret 3 Mo (Qtr-End) EUR | Total Ret 3 Mo (Qtr-End) USD | Total Ret 3 Mo (Qtr-End) JPY |
|---|---|---|---|---|
| Sterling High Yield Bond | -1.31 | 3.01 | -1.61 | 7.20 |
| Sterling Government Bond | -1.72 | 2.58 | -2.02 | 6.76 |
| Sterling Global Bond | -2.11 | 2.17 | -2.41 | 6.33 |
| Sterling Diversified Bond | -3.00 | 1.24 | -3.30 | 5.36 |
| Sterling Corporate Bond | -5.48 | -1.35 | -5.77 | 2.67 | |
Government bond funds also continued to do relatively well across the board. In terms of duration (a measure of a bond fund's sensitivity to interest-rate changes) short-duration funds continued to outpace their longer peers. This is to be expected in an environment where rates are easing: Bond prices move inversely to rates, so funds with less interest-rate sensitivity (shorter duration) fare better when rates are falling.
| Morningstar Category | Total Ret 3 Mo (Qtr-End) GBP | Total Ret 3 Mo (Qtr-End) EUR | Total Ret 3 Mo (Qtr-End) USD | Total Ret 3 Mo (Qtr-End) JPY |
|---|---|---|---|---|
| Dollar High Yield Bond | 2.95 | 7.45 | 2.63 | 11.83 |
| Dollar Short Bond | 0.93 | 5.34 | 0.62 | 9.63 |
| Dollar Government Bond | -0.43 | 3.93 | -0.73 | 8.16 |
| Dollar Diversified Bond | -0.98 | 3.35 | -1.28 | 7.56 |
| Dollar Global Bond | -2.01 | 2.27 | -2.31 | 6.44 |
| Dollar Corporate Bond | -4.06 | 0.14 | -4.35 | 4.22 | |
| Morningstar Category | Total Ret 3 Mo (Qtr-End) GBP | Total Ret 3 Mo (Qtr-End) EUR | Total Ret 3 Mo (Qtr-End) USD | Total Ret 3 Mo (Qtr-End) JPY |
|---|---|---|---|---|
| Euro High Yield Bond | -0.63 | 3.72 | -0.93 | 7.94 |
| Euro Inflation Linked Bond | -3.32 | 0.91 | -3.61 | 5.02 |
| Euro Government Bond | -3.75 | 0.46 | -4.04 | 4.55 |
| Euro Short Bond | -3.77 | 0.44 | -4.07 | 4.53 |
| Euro Global Bond - Hedged | -4.08 | 0.12 | -4.37 | 4.19 |
| Euro Global Bond | -4.58 | -0.41 | -4.88 | 3.64 |
| Euro Diversified Bond | -4.62 | -0.44 | -4.91 | 3.61 |
| European Bond | -4.76 | -0.60 | -5.06 | 3.45 |
| Euro Long Bond | -5.82 | -1.70 | -6.11 | 2.30 |
| Euro Corporate Bond | -6.51 | -2.42 | -6.80 | 1.55 | |
Q1: Industry Trends
Continuing a trend from 2008, there was a large number of fund class closures in 2009's first quarter. We expect this scaling back to proceed for some time as we believe fund groups over-expanded during boom years and offered far too many niche funds that will be unable to achieve the scale needed to operate profitably. 1,439 fund classes were liquidated or merged into other classes in the quarter. That's a marked year-over-year increase with just 891 being liquidated or merged in the first quarter of 2008. The trend of increasing closures is made clear in the chart below.
We also note that asset managers themselves are undergoing a wave of mergers and acquisitions fostered by market pressures. BNP Paribas, Fortis, Societe Generale, GLG Partners, Credit Agricole, Credit Suisse, Aberdeen, New Star, Henderson, and F&C among others are all involved in deals. This heightened activity is likely to result in further fund mergers and liquidations: As houses come together, they will need to reduce or eliminate overlap in their fund line-ups to achieve cost savings and economies of scale.
Ultimately, we think the scaling back of fund offerings is needed. However, we urge investors and regulators to monitor the situation carefully. We have too often found that merger activity among fund companies leads to poor outcomes for fund investors. This is because significant decisions are taken primarily on the basis of what is best for the fund house as a business, and regard for fund-shareholders' needs can be lost in the process. For example, investors may suddenly find themselves with unwanted or unintended risk exposures if their fund is merged into a different offering or its mandate is changed; asset bloat may hamper liquidity-constrained fund managers if they are handed new pots of money to run as part of a merger; investment talent may leave or be asked to leave; and/or investors may see that their fees have risen as an acquiring firm attempts to recoup its investment faster. In such situations, there are few protections for fund investors, which points to a rather large failing in the current regulatory system.
