Academics have long argued that index funds can outdo most active managers. But the rough markets of recent years have blown a hole in the academic theories. During the ten years ending in May, Vanguard Index 500 (VFINX), the granddaddy of index funds, lagged 55 percent of its large blend competitors, according to Morningstar. In the same period, the average actively managed small blend fund surpassed the Russell 2000 index.
The active funds took the lead partly because they held cash, a winning asset during downturns. Can active managers continue beating their benchmarks if the market climbs for the next decade? Maybe not. But the odds of success seem particularly good for at least one category: world stock funds, which hold mixes of domestic and foreign shares. During the past decade, world funds returned 1.91 percent annually, 2.25 percentage points more than the MSCI World index and 3.60 points ahead of the S&P 500.
In their efforts to surpass the benchmarks, world funds enjoy some advantages. For starters, portfolio managers can pick stocks anywhere in the world. That leaves plenty of room to find undervalued shares. In addition, major global trends can be relatively easy to identify and exploit. For example, many active managers gained ground on the benchmarks by underweighting Japan, one of the worst-performing markets for the past two decades. From 2002 to 2007, some funds overweighted Europe, a winning move during a period when U.S. stocks trailed.
A World Fund Simplifies Things
Despite their advantages, world funds are often overlooked. Instead of using a single world fund, most advisors prefer dividing their assets, holding separate overseas and domestic portfolios. By splitting their assets, advisors say that they can control the allocation to foreign stocks.
If you buy a world fund, the portfolio manager makes the decision about how to allocate assets abroad. That makes the world funds attractive for some advisors. “Determining the right allocation to international stocks is difficult,” says Mark Bredin, president of Bredin Investment Services, a financial advisor in Malvern, Pennsylvania, who uses world managers. “When you pick an experienced manager, you can take someone who has a long track record for making good decisions about allocations.”
For advisors, world funds can simplify portfolio management. Consider that advisors who use separate domestic and international funds must set the allocations and constantly monitor them. When international funds become overweighted, advisors must rebalance by selling some shares, possibly producing taxable gains. If advisors decide to increase the international allocation, they must have difficult conversations with clients, explaining why now is the time to put more assets abroad. By using world funds, advisors can avoid many of the problems of rebalancing.
Some advisors argue that world funds should become more popular because they are suited to today's global economy. While a domestic fund manager may seek to find the best U.S.-based pharmaceutical or technology stocks, a global manager can travel anywhere looking for the top companies in the world. “We are in a world where multinational companies are global,” says Donald Robinson, chief investment officer of Lockwood Capital Management, an investment advisor. “It may not pay to ignore a company just because the business is headquartered in a particular country.”
For a world fund that is a steady value player, consider Templeton Global Opportunities (TEGOX). Portfolio manager Guang Yang forecasts a company's earnings for the next five years and buys when shares sell at big discounts to fair values. Once he buys, Yang holds for years. The fund's annual turnover has been 12 percent, compared to 91 percent for the category average.
Yang stays broadly diversified, holding sizable stakes in the emerging markets of Asia as well as shares in Europe and the U.S. “To offset the volatility of the emerging markets, we have some blue chips in the developed world,” he says.
A blue-chip holding is France Telecom (FTE), which records steady revenue from fixed-line business. The company pays a solid dividend yield of nearly 9 percent.
A fund that fits in the blend box is Oakmark Global (OAKGX). The managers seek out-of-favor plays, but they are not interested in troubled businesses. Instead Oakmark prefers companies with strong niches and rich cash flows. A big holding is chip giant Intel (INTC). “This company is at a cyclical low now, but it will grow over the long term,” says portfolio manager Rob Taylor.
Searching for undervalued stocks, Oakmark shifts periodically, sometimes overweighting the U.S., while other times favoring foreign shares. In 1999, the fund had 60 percent of assets in the U.S., including many undervalued small stocks. But then as U.S. prices climbed, Oakmark began moving overseas. By 2005, the fund had only 30 percent of assets at home.
MFS Global Equity (MWEFX) lands in the growth box. The fund focuses on established companies that can deliver growth for many years. The list of holdings includes such blue chips as French luxury goods maker LVMH Moet Hennessy (LVMHF.PK) and PepsiCo (PEP). Most assets are in the developed markets, with 37 percent of the portfolio in the U.S.
A favorite holding is Swiss giant Nestle (NSRGY.PK). “This is a low-risk business that should be able to deliver high returns for the foreseeable future,” says portfolio manager Ben Kottler.
To hold small and mid-cap stocks, consider BlackRock Global SmallCap (MDGCX). The fund stays broadly diversified, typically holding between 125 and 200 names. The portfolio includes a mix of growth and value stocks. “We are looking for good small companies that will go on to become bigger companies,” says portfolio manager Murali Balaraman. “We are not concerned about whether a stock fits into a particular style box.”
A longtime growth holding has been Ryanair (RYAAY), the Irish discount airline. Having observed the success of Southwest Airlines in the U.S., Balaraman figured that Europe would offer great potential for a discount operation. He bought Ryanair when it was a small cap, and has held on now that the shares have grown into mid-cap territory.
Another way to own small stocks is AIM Global Small & Mid Cap Growth (AGAAX). The fund looks for companies that can deliver sustained growth, but AIM is not willing to pay sky-high prices. “We do not look for the fastest growing companies because they tend to be very expensive,” says Andrew Pringle, a senior portfolio manager.
Many AIM holdings have little debt and strong balance sheets. That has helped the fund hold up in downturns. A big holding is Syngenta (SYT), a Swiss maker of pesticides and chemicals used for agriculture. Pringle figures that sales should remain healthy as farmers around the world struggle to increase their production.
