Fund Spotlight

Small-cap stocks had rebounded from a poor 2014 performance before the latest round of selling and lower exposure to global markets meant they were less hampered by a stronger U.S. dollar and the economic slowdown than their large-cap counterparts. Recent selling in the equity market has hit small-caps harder as they tend to be more volatile, but when the selling subsides, they should resume their leadership. Strong gains in the biotech sector and exposure to technology are key in lifting this segment of the market.

A beneficiary of this strong market performance has been the Janus Venture Fund (JAVTX). This small-cap growth fund seeks capital appreciation by investing at least 50 percent of assets in smaller companies whose size falls within the range of firms listed in the Russell 2000 Growth Index, the fund’s benchmark. The four-star Morningstar-rated fund may also invest in larger companies that have the potential for strong growth or capital appreciation as well as foreign shares, including investments in emerging markets. It is closed to new investors, but those who hold it can add to their positions. We will also identify a number of funds that deliver similar exposure for those investors who may not be able to access JAVTX.

Investment Strategy

Jonathan Coleman has been at the helm of the Janus Venture Fund since May 2013. He is supported by six small- and mid-cap analysts who together average 9 years of experience at Janus. Coleman also has more than $1 million personally invested in JAVTX. The fund’s impressive return in 2014 surpassed more than 85 percent of its small growth category peers as well as its benchmark Russell 2000 Growth Index. Although the fund’s focus has not changed, Coleman has increased the number of holdings and lowered the concentration of individual positions to create a more diverse portfolio. Top holdings will rarely exceed 2 percent of assets. The fund’s metrics for profitability, such as returns on assets and equities, as well as its debt/capital ratio are less stringent than the category averages. The fund manager selects stable performers and rarely overpays for stocks with rapid growth and higher valuations. Coleman is a patient investor with experience utilizing this risk-conscious approach. Management selects potential candidates from the bottom up; each company is screened to ascertain whether it is consistent with the fund’s objective while providing an attractive investment opportunity. The team looks for companies with growing revenue streams that generate high returns on invested capital and have a proven ability to expand their profit margins. They also seek companies with other competitive advantages, such as pricing power and high barriers to entry.

Portfolio Composition and Holdings

With $2.8 billion under management, JAVTX has an 89 percent exposure to domestic stock and a 6.40 percent investment in foreign issues. The balance of 2.42 percent is held in cash. The fund is slightly underweight domestic stocks and overweight foreign shares when compared with the benchmark index. JAVTX has exposure to the United Kingdom, Developed Europe and Africa/Middle East. The fund currently has no direct exposure to China, Japan or the rest of Asia. The portfolio is allocated 33 percent in mid-cap shares as well as 52 percent and 15 percent in small- and micro-cap shares, respectively. The result is a portfolio with an average market cap of just over $2.5 billion, while the benchmark average is only $1.67 billion.

The fund is overweight the industrial and technology sectors and underweight healthcare and consumer cyclicals. The top 10 holdings comprise 17 percent of assets. The major holdings in descending order are SS&C Technologies, Sensient Technologies, Rexnord, EnerSys and Cadence Design Systems. These five are followed by Broadridge Financial Solutions, HEICO Corp., Euronet Worldwide and NICE Systems Ltd. The fund has a P/E ratio of 25.77 and a price-to-book ratio of 3.20.

Historical Performance and Risks

The fund’s approach of focusing on high-quality stocks has enabled it to surpass its small-cap category average over the past 1-, 3-, 5- and 10-year periods. Over these time frames, JAVTX has generated total returns of 5.50 percent, 13.81 percent, 15.26 percent and 8.98 percent. This compares to the category performance of 2.43 percent, 11.18 percent, 12.14 percent and 7.04 percent, respectively. These returns are a direct result of the management team’s focus on investments in the industrial and biotech sectors. Top contributors include Synageva BioPharma, Dyax Corp., Eagle Pharmaceuticals, Blackbaud Inc. and Atmel. Stocks that detracted from the overall performance were Pernix Therapeutics, Puma Biotechnology, Solera, Wolverine World Wide and top 10 holding Rexnord. September weakness in the biotechnology sector has the fund trailing its category in 2015.

JAVTX garnered a below-average risk rating from Morningstar. The fund’s 3-year beta and standard deviation are 0.85 and 12.67. These compare to the 0.82 and 14.12 average ratings, respectively, for the small-cap growth category.

Investment Options

JAVTX has an overall low expense level rating from Morningstar and charges 0.93 percent, but the fund is closed to new investors. There are other share classes available, such as JVTAX, but it has an initial front-end load of 5.75 percent, a 12b-1 fee of 0.25 percent and an expense ratio of 1.17 percent. Although it is a good fund, those fees are enough to dissuade us from recommending it.

A similar fund is Strategic Advisers Small-Mid Cap (FSCFX). With an expense ratio of 0.37 percent, the fund is much cheaper than the Janus fund, but it has trailed the category average over the past 1-, 3-, 5- and 10-year periods. PIMCO StocksPLUS Small (PCKDX) has better returns than FSCFX, but has trailed JAVTX. It is also more expensive, with a 1.09 percent expense ratio. The best alternative is Fidelity Small Cap Growth (FCPGX), which charges a similar 0.90 percent expense ratio and has returns that are very competitive with JAVTX.

Outlook

By maintaining its focus on companies with resilient business models, JAVTX should be well positioned to weather a variety of market situations and experience moderate growth. The fund’s management team bases their approach on an improving U.S. economy as well as an increase in volatility and a lower aggregate return in the coming months. The manager anticipates continued high valuations for small-cap stocks, which can be offset if companies demonstrate appreciable earnings growth going forward.

While the firm’s hiring of Bill Gross may benefit its fixed income funds, it is still too soon to determine if there will be a positive impact on the equity side. The recent turnover in fund managers and the need to hire additional outside talent has led Morningstar to rate Janus a D for its corporate culture and a neutral for the Venture fund. As the fund is closed to new investors at the moment, sticking with a Fidelity option makes sense for similar exposure.

We have recommended Vanguard’s Global Minimum Volatility Fund (VMVFX) for quite some time. The fund utilizes a number of beneficial strategies, such as low volatility and currency hedging, while taking a global approach to equities. This results in a solid core holding for investors looking for international exposure amid a U.S. dollar rally. This month we are going to reevaluate VMVFX and see how it has performed over the past year to determine whether it is likely to be a good investment over the months ahead.

Historic Dollar Rally

Over the past year we have seen one of the largest U.S. dollar rallies since the currency became untethered from gold in 1973. The U.S. Dollar Index has 57.6 percent of assets in the euro, plus 13.6 percent in the yen, 11.9 percent in the pound, 9.1 percent in the Canadian dollar, 4.2 percent in the Swedish krona and 3.6 percent in the Swiss franc. The index has climbed from 80 in July 2014 to over 100 in March, before settling into the 90 range more recently. This 25 percent advance in our currency has been fueled by Europe’s decision to launch a quantitative easing program in January, a move that was anticipated for months before the announcement. More recently, weakness in China weighed on the Canadian dollar, while Japan’s consistent policy of currency devaluation since 2012 has benefited the greenback.

As a result of recent market changes, various international funds faced currency headwinds of varying strength. For example, Vanguard European Stock (VGK) slipped 7.98 percent over the past year. WisdomTree European Hedged Equity (HEDJ), which hedges out currency exposure, gained 5.93 percent. The gap of 13.91 percent was largely explained by the drop in the euro, which fell 15 percent over the same period.

Vanguard Global Equity (VHGEX) has fallen 5.24 percent over the past year, while VMVFX has gained 8.88 percent. The gap of 14.12 percent more closely approximates the gain in the U.S. Dollar Index. About half of each fund is invested in the United States, while the remainder is invested overseas. If one were to assume the only difference between the two portfolios was currency hedging, the expected difference would roughly approximate the currency changes on the overseas half of the portfolio, or approximately 12 percent. In this case, VMVFX performed better than the currency changes alone would predict.

The performance gap over the past year illustrates the appeal of VMVFX. The fund will outperform during a U.S. dollar bull market, and the bulk of its gains will come through the avoidance of currency losses.

VMVFX

Low volatility indexes are similar to other broad market indexes, but focus on the volatility of individual stocks. This can create a potentially risky portfolio due to sector concentration, as sectors such as utilities have lower than average volatility. Overall, the portfolio would have a lower degree of volatility on paper, but if there were a sector specific event, the portfolio could experience much higher than anticipated losses. VMVFX aims to remove this risk; managers examine the correlation between individual stocks in the portfolio and adjust exposure in order to deliver a more diversified portfolio.

When considering a low volatility fund, it is important to remember that volatility is a measurement of only one type of risk. A low volatility fund is expected to fluctuate less than a high volatility fund, but it isn’t going to buck the overall market’s trend. If stocks are headed higher, the low volatility fund will move higher; if stocks are falling, it will fall too. This risk is called market risk, and it is represented by beta. Generally speaking, we can say a low volatility fund is expected to fluctuate less than a regular index fund, but whether it performs better or worse will depend on other factors such as sector exposure.

Low volatility became a popular investment strategy in recent years as research indicated that low volatility stocks, though not favored by investors, performed better than the market as a whole. Tobacco stocks such as Altria Group (MO) were shunned by investors for ethical reasons but, despite their businesses being steady and monotonous, persistently outperformed the stock market for decades. There are many such uninspiring companies in the stock market – firms that are in the same line of business with no major expansion plans, technological breakthroughs or aggressive growth strategies. Many investors look to strike it rich, searching for “hot stocks” – companies launching new products, entering new markets or creating new technology. This leads to an undervaluation of low volatility companies while stocks with higher volatility are prone to overvaluation.

VMVFX is well diversified, with the largest sector (healthcare) responsible for less than 17 percent of assets. That is roughly in line with major indexes such as the S&P 500 Index. In contrast, some low volatility funds have well over 20 percent of their assets in utilities, while VMVFX has only a small weighting of 7 percent in the portfolio.

While VMVFX is actively managed, the expense ratio is a reasonable 0.30 percent. The fund is not tax efficient due to the high turnover rate required to maintain its minimum volatility mandate. VMVFX also hedges currency exposure, which can be beneficial when the U.S. dollar is strong, but could lead to underperformance during periods of weakness. Investors who hope to maximize the upside from this fund will want to consider the overall trend in the U.S. dollar. The bulk of the difference in performance between this fund and the average global fund will come down to the direction of the U.S. dollar.

Conclusion

Global Minimum Volatility (VMVFX) performed exceptionally well over the past year. The fund’s currency hedging paid off handsomely as the U.S. dollar experienced a historic rally, one of the largest in the past 40 years. In the past few decades, the U.S. dollar has experienced bull and bear cycles of roughly six years’ duration. The rally to this point is barely more than one year old and, for investors looking for overseas exposure, hedging out foreign currency risk amid a U.S. dollar rally could meaningfully impact returns to the upside. We will continue to recommend this fund as it provides excellent returns and sound management at a low cost.

In the wake of the commodities sell-off, yields on energy giants such as Chevron (CVX) and Exxon (XOM) have reached 5 percent and 3.7 percent, respectively. Income-oriented investors are no doubt tempted by those yields, but analysts are concerned about the dividend payments from ConocoPhillips (COP), which yields 5.9 percent at recent prices. The primary risk for these energy companies would be falling oil prices, which would squeeze their ability to pay investors while making capital investments. Without those investments, future growth, and hence future dividend growth, would be at risk. In order to avoid that sector-specific risk, investors may want to consider diversified dividend funds as a better option than individual stocks.

The Investor Class Vanguard High Dividend Yield Index Fund (VYM) is a large-cap, no-load mutual fund that seeks to track the performance of the underlying benchmark FTSE High Dividend Yield Index. It employs an index investing approach by allocating most of its assets in stocks that make up the index. These stocks are common shares issued by companies that pay a higher-than-average dividend. The fund’s low cost and historical performance earn it a Morningstar Analyst Rating of Silver. There is also a mutual fund class of this product, which trades under the ticker symbol VHDYX. Approximately 75 percent of the $16 billion in assets under management are held in ETF shares.

Investment Strategy

The fund’s market cap-weighted portfolio comprises more than 400 U.S. stocks that have been selected based on their yields. It has been led by Michael Perre since its inception in 2006, and its managers shy away from small- and mid-cap stocks that may offer greater returns but are also inherently more risky. The passive, market cap-weighting investment style reduces turnover. At 17 percent, the fund’s turnover is well below the 55 percent average for the large value category. Broad sector diversification mitigates risk.

Dividend-paying stocks are seen as defensive because they have outperformed non-dividend-paying stocks since 1926. The fund is not without risks; some companies that pay higher dividends can become distressed and cut their payments. To reduce this risk, the fund managers tilt their investments toward large global conglomerates with competitive advantages, such as Exxon Mobil, General Electric (GE) and Johnson & Johnson (JNJ), while avoiding potentially riskier names like Freeport-McMoRan (FCX). That strategy has paid off; FCX has declined 58 percent since May, while XOM has lost only 13 percent. VYM is fully invested in the market at all times.

The fund tracks the FTSE High Dividend Yield Index, which is composed of dividend-paying stocks excluding micro-caps, MLPs and REITs. The managers sort stocks by dividend yield and add to the index starting with the highest-yielding issues until the index portfolio’s market cap equals 50 percent of the market cap of all dividend-paying stocks. The index is then market-cap weighted. The result is a value portfolio that encompasses approximately 38 percent of the total market.

Portfolio Composition and Holdings

The fund has a 98.53 percent exposure to domestic shares, a 0.86 percent exposure to foreign stocks and a less than 1.0 percent cash position. With an average market cap of $73 billion, VYM has 58 percent of assets in giant caps as well as a 27.37 percent, 10.48 percent and 3.12 percent allocation to large-, medium- and small-cap shares, respectively. The mutual fund is overweight the consumer defensive sector, while underweight real estate and consumer discretionary. The portfolio has a P/E ratio of 16.66 and a price-to-book of 2.25, higher than those of the Russell 1000 Value Index. Stocks within the portfolio have an average dividend yield of 3.4 percent.

The fund has 30.48 percent of assets in its top 10 holdings. These include Exxon Mobil, Microsoft, Wells Fargo, Johnson & Johnson and General Electric. The next five in descending order are JPMorgan Chase, Procter & Gamble, Pfizer, Verizon and AT&T. It also holds 53 percent of assets in shares that have a wide Morningstar Economic Moat Rating, which compares with the category average of 37 percent.

Historical Performance and Risk

The fund’s managers have done their job well as VYM has less than a 10-basis-point tracking error. From its inception through April 2015, VYM has returned an annualized 6.9 percent. Although this is less than the 7.1 percent of the S&P 500, value has underperformed during the past decade. On the plus side, the fund has a lower standard deviation.

Over the same period, VYM beat the large value category’s average return of 5.1 percent. For its past 1-, 3- and 5-year periods, VYM has generated average return of 7.44 percent, 14.11 percent and 15.23 percent, respectively. The comparable category averages were 5.98, 14.55 and 13.04 percent. VYM has a 30-day SEC yield of 3.22 percent, while VHDYX has a 30-day SEC yield of 3.15 percent.

Risks, Fees and Expenses

The four-star Morningstar rated VYM has no minimum investment, but VHDYX has an initial minimum investment of $3,000. The fund has an average Morningstar risk rating with its 3-year beta of 0.90 and a standard deviation of 8.64. This compares with the category beta and standard deviations of 0.98 and 9.03. The expense ratio for VYM is 0.10 percent. VYM has a net expense ratio of 0.18 percent, with no 12b-1, initial, deferred or redemption fees.

Outlook

VYM has seen a net inflow of $10 billion over the past five years as dividend-paying stocks have become increasingly popular with income investors. VYM may experience a sharp pullback if interest rates rise or there is a major sell-off in the market that causes investors to give up on income-oriented investments. The fund lagged the S&P in 2013 when interest rates rose and underperformed during the financial crisis. One reason for the latter was the inclusion of financial stocks, which used to be strong dividend payers. That sector is now underweight in the fund relative to the broader market. While the fund’s resources-related holdings may also be a drag on return in light of the recent sell-offs in oil and other commodities, VYM has a solid yield and good exposure to the healthcare and technology sectors.

The damage caused by the sell-off in the resource space, along with the recent bankruptcies in the coal industry, may not be over. The main catalyst appears to be an excess of supply in the face of an unanticipated slowdown in the Chinese economy, which may take several years to work off. VYM has a bit more exposure to the commodity space, mainly energy, than the broader market. As a result, investors should be aware of the performance risk moving forward, as opposed to blindly chasing the fund’s attractive yield. For long-term investors looking for income-generating investments, any further pullbacks in energy or the broader market could provide some very attractive entry points in VYM.

Equity markets have been generally flat this year and PRIMECAP (VPMCX) has been no exception, with a small gain of 1.25 percent through July 10. The fund is closed to new investors, but it remains a great core holding for investors who already hold it in their portfolios. With certain funds, such as health care, rising double digits in the first half, some investors with overweightings in that sector should consider rebalancing assets back to core holdings such as VPMCX or VIG.

The five-star Morningstar rated VPMCX seeks long-term capital appreciation and invests primarily in large- and mid-cap stocks that the managers believe have an above-average earnings growth potential not reflected by their current stock price. The fund has the flexibility to invest across all market segments and capitalizations. VPMCX may also invest up to 25 percent of assets in foreign issues. PRIMECAP Management Company, the fund advisor, utilizes an investment approach in which multiple managers each oversee a portion of the portfolio. Established in 1984, the fund continues to use this well-established investment strategy to manage more than $46 billion in assets.

Investment Strategy

VPMCX is led by an experienced team that includes co-founder Theo Kolokotrones. The management team also includes co-managers Joel Fried, Al Mordecai, M. Mohsin Ansari and James Marchetti. Each portfolio manager runs his own sleeve independently with the assistance of the firm’s 13 analysts. As managers and analysts prove themselves to be strong stock pickers, they receive larger portions of the fund to invest. This approach avoids groupthink and ensures a diversified portfolio. The fund may have a tilt toward certain industries and sectors as more than one manager may find them attractive, such as the current concentration in pharmaceuticals, biotech and information technology shares. Managers have aligned their interests with those of investors by having substantial personal investments in the fund.

Fund managers use what has been described as a patient contrarian growth approach to stock selection. Managers look for companies that have demonstrated rapid growth in the past and have the potential for continued future growth but have temporarily fallen out of favor. They are willing to wait for the stocks to rebound, as long as the underlying fundamentals remain unchanged. Managers anticipate holding shares for at least three to five years. The result is a low turnover rate, which is typically around 10 percent compared to the annual category average of 60 percent. Shares are generally sold when valuation targets are reached or there has been a significant change in the underlying fundamentals. There is no standard method for valuing stocks. Each holding or potential addition is evaluated on a case-by-case basis using independent research and a variety of analytical tools. The fund does not have an explicit market-cap limit as to which shares can be purchased.

Portfolio Construction and Holdings

This large-growth category fund holds 124 individual issues with a median market cap of $63.3 billion. It is allocated 83.65 percent in domestic shares, 11.2 percent in foreign stocks and 5.15 percent in cash. Foreign shares are concentrated in companies headquartered in Developed Europe. VPMCX has a giant-cap weighting of 50.88 percent and a large-cap allocation of 42.03 percent. It has a mid-cap exposure of 6.51 percent, which is significantly less than the category average of 17.84 percent. With 93 percent of holdings in large- and mega-cap shares, the fund is overweight these big cap stocks compared to the category average of 81 percent.

The fund’s top 10 holdings comprise 41.43 percent of assets under management. In descending order they are Biogen, Amgen, Eli Lilly, Texas Instruments and Microsoft followed by Roche Holdings, Adobe Systems, FedEx, Google and Novartis. VPMCX is underweight consumer staples, energy and financials. The portfolio has a P/E ratio of 21.4 and a price-to-book ratio of 4.0. The fund has a 19.6 percent average return on equity.

Performance, Risks, Fees and Distributions

With its high-quality portfolio, VPMCX held up during the 2008 market crash. It performed well in 2013 and 2014 as health care and tech shares dominated the market. After its managers were named Domestic-Stock Fund Managers of the Year by Morningstar for their impressive numbers for 2014, the fund has dropped from the top 1 percent to the bottom quartile as of mid-year 2015. The fund’s holdings in Southwest Airlines had a negative effect as airlines stocks have underperformed recently after a strong showing last year. Large-cap stocks have also underperformed the market this year, reflected in the small loss in the Dow Jones Industrial Average and small gain in the S&P 500 Index. The size of the fund also makes it difficult for VPMCX to own shares in some of the recent smaller high-flying biotech and information technology stocks. Despite the drop in the ranking, VPMCX still retains a Gold Morningstar analyst rating.

Boasting a high Morningstar return rating, VPMCX has average 1-, 3- and 5-year total returns of 7.32 percent, 22.17 percent and 19.07 percent respectively. These compare to the Large Growth category averages of 7.98 percent, 17.69 percent and 17.47 percent over the same periods. VPMCX has a below-average risk rating. The fund has a three-year beta and standard deviation of 0.92 and 8.58, which compare to the category averages of 1.00 and 16.14 respectively, making VPMCX much less volatile than the competition. Over the past three years, VPMCX has had an above category-average upside capture ratio of 106.22 and a below category-average downside capture ratio of 62.96. The fund has a 1-year trailing return of 14.6 percent and a 30-Day SEC Yield of 1.17 percent.

Vanguard funds often have the lowest fees in the industry. This large-cap no-load fund has an expense ratio of 0.44 percent, very low for an actively managed fund. The category average is 1.19 percent. On December 22, 2014, VPMCX had dividend, long-term and short-term distributions of $1.16, $5.667 and $0.041 per share with a reinvestment price of $104.39. Investors should be aware of the potential tax impact in December; if managers take profits on long-term holdings, there could be significant capital gains.

Outlook

The fund is currently overweight health care and technology. While it may demonstrate short-term volatility as it makes some concentrated investments, the overall strategy has produced strong long-term results. VPMCX is an excellent core holding in a well-diversified portfolio.