How Top Fund Managers are Playing The Markets

American Investors' 'Bunker Mentality' Biggest Hurdle For Managers

As the three-day Morningstar Investment Conferencecomes to a close, the common theme has been the fund manager's collective plight: dealing with timid American investors.

Morningstar Investment Conference
Photo by Jennifer Parker for
Morningstar Investment Conference

"Americans are in a bunker mentality right now, not knowing whether they want to invest. And when they come out of the bunker, they won't step full on the gas like the baby boomers looking to get rich off their retirement," said Scott Burns, Morningstar's director of fund research. "Generation X, the bulk of investors, are looking lot more cautious."

This reality has the pros debating best ways to coax timid investors off the sidelines and back into the stock market.

GMO's star investor Jeremy Grantham, for example, is doing this by being underweight US equities, and overweight international stocks. He says he's positioning himself for a risk-off, "slower growth world."

Going international, as it turns out, is a popular strategy.

"There are more attractive stocks in international marketstoday. For one, they’re much more fairly valued — and cheaper," said John Fenley, portfolio manager for the Westcore International Small Cap Fund .

"There are also much fewer investors chasing international stocks compared to US equities," added Fenley. "That, and the last time valuations were this low for internationals was the first quarter of 2009, so there's a lot of upside once market fear has subsided."

There is an inherent hurdle, however, to investing in international equities, according to Fenley. "If euro debt crisis concerns persist, it may cause share prices — and the fund’s value to go lower. That’s what keeps me up at night."

While Fenley tosses and turns, most fund managers here seem hopeful that a working solution to the European debt crisis will at least bring investors back to the table.

"While I think greed ultimately overcomes fear, I don't know if American investors will get back to a risk-seeking mentality," said Burns of Morningstar.

Why ETFs Are Hottest Ticket Here

Why ETFs Are the Fastest Growing Area in Finance: Pros
5 p.m. ET, June 21, 2012

A cutting-edge, ETF managed portfolio is about the hottest ticket at the Morningstar Investment Conference. About half of all of U.S. investors' portfolios are allocated to ETFs, according to Morningstar, and the numbers are growing rapidly.

Emerging Markets Globe
Saul Gravy | Photographer's Choice | Getty Images
Emerging Markets Globe

Morningstar's ETF gurus say the reasons are threefold: minimized risk, diversification, and tactical \(short-term\) flexibility.

"We have pretty much minimized security selection risk with ETFs. That's the value-add," said James Peters, advisor for the Tactical Allocation Group, which runs the TAG Moderate ETF Portfolio.

Most ETFs track an index, avoiding the risk individual securities can pose.

"The most important upside is risk management," says Mazin Jadallah, chief executive of AlphaClone, the index provider for AlphaClone Alternative Alpha ETF.

Jadallah of AlphaClone, referring to the ETF as a "virtual hedge fund of funds," says he's able to protect against extreme market downturns by hedging against market volatility — much the way a long/short hedge fund is designed to do.

Demand for Alternative ETFs

Diversification is another important asset for ETFs, experts say. The strategy offers investors access to asset classes around the world that would otherwise be restricted.

"I think everyone's trying to move into further diversified portfolios. We're seeing a lot of interest in very diversified strategies. A lot of the low hanging fruit has already been taken, but in the alternative space, ther'e still development taking place. So we're working on creating new ETFs," said Thomas Fox, chief investment officer for Quantitative Advantage, which runs the QA Tactical All Market ETF.

In fact, Jadallah's AlphaClone ETF is the result of alternative ETF demand. Launched May 31, this newbie can't show a performance track record yet, but already is getting attention at Morningstar.

"Its a big deal because it gives investors access to the investment ideas of established hedge fund managers they otherwise would not have access to," Jadallah told in a separate interview.

Skeptics might doubt an ETF could replicate a hedge fund's strategy at all.

Jadallah counters: "What we're trying to do is replicate the alpha [market outperformance] in a manager's stock selections. The best stock pickers of the world work at hedge funds. As a category they've suffered, but there are outperformers."

Tactical and Nimble Investing

Time will tell. Meanwhile, a "tactical approach" — industry talk for short-term allocation changes to a portfolio — is the final attraction for these pros.

"I've heard people say large cap value is in a bad cycle. So why keep holding it? Clients get this. The ETF is a tool that absolutely increases your ability to be tactical," saidPeters.

Fox at Quantitative Advantage is a big fan of the tactical approach. His exposure includes real estate investment trusts or REITs.

"We've been in REITs for a while. Right now, we're actually short emerging markets. We've also been in currencies, specifically the Chinese Yuan. We're a trend-oriented strategy, but we've been able to navigate well," added Fox.

Without being tactical, Fox says he might miss out on opportunities to tap these widely diversified asset classes when they arise.

What to Do When Cash Is Trash


What to Do When Cash Is Trash
1:52 p.m. ET, June 21, 2012

Why is cash trash? The Federal Reserve's zero interest rate policy means plain ol' savings accounts don't earn interest, and the most recent Fed signals say this isn't changing any time soon.

While this isn't new, fund managers' approach to cash in their portfolios is. Accessing liquidity through money market funds is the common goal for these top managers.

"People investing in money market funds are demanding immediate liquidity. For us, in terms of cash management, short-dated investments are most beneficial to the investor," said Jerome Schneider, executive vice president and manager of PIMCO's Short-Term Institutional Fund.

Investors view money market funds as cash because they're priced at a $1, so if you allocate $100, you get $100 back. Money market funds buy very short-term bond instruments (CDs, commercial paper, and "repos," or repurchase agreements). This underlying investment strategy is seen as so simple, there is no need to lock up funds — keeping cash accessible.

Getting back exactly what you put in isn't exactly exciting, however, and these guys concede the difficulty of squeezing returns out of money market funds.

"It's return of capital, not return on capital," said Bob Brown, Fidelity's bond group president. "We have entered a global marketplace where systemic risk will be with me my entire career. That said, we believe the reforms implemented after the financial crisis made for much stronger money market funds, and there is high demand for them."

There's about $2.6 trillion sitting in money market funds right now, said Brian Reid, chief economist for the Investment Company Institute. "Investors find the core features attractive," he added.

The core feature, of course, is safety. People tend to put cash in money market funds when times get tough because they contain separate securities, making them safer than a deposit cash account if a bank were to fail.

The skill in getting the most out of money market funds, says Pimco's Schneider, is to "define your immediate liquidity needs. If you can do that, then you know how to deploy your 'cash' in difference environments — and there are probably 200 different liquidity needs in this room."

"Whacko" Capital Structures

Capital Structures Gone "Whacko"
11:03 a.m. ET, June 21, 2012

U.S. corporate balance sheets are strong, but top portfolio managers are worried that companies will have a harder time keeping both stock and bondholders happy.

And if Washington raises corporate taxes, it will get even tougher when it comes to positioning in the capital structure \(starting with senior debt, which companies pay first, on down to stockholders, who lose out first if a company files for bankrutpcy protection, but are first to gain if share prices soar\).

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"There are times when the capital structure does get flipped. They've gone whacko in the past, and they can again," said Don Yacktman, president of Yacktman Asset Management, which primarily invests in equities in the Yacktman Fund.

"You've got to ask where are you getting paid best in the capital structure? Quite frankly, I think corporate bonds beat equities. For many companies, it's best to be in equity, but bondholders are benefiting more right now overall," said Mark Kiesel, the portfolio manager leading Pimco'sinvestment grade corporate bond fund .

Kiesel cites financials to support his strategy: "The banking industry right now is not in an equity-friendly mode. Regulators are making share buybacks tougher, so it's a very conservative industry right now, and that's good for bondholders."

Pimco's open-end mutual funds are currently coming in second, behind Vanguard in Morningstar's Top 10 list, attracting about $17.5 billion net new inflows year-to-date.

For Meggan Walsh, dividend paying stocks are the way to go. This, of course, is reflected in the portfolio she manages, Invesco's Diversified Dividend Fund .

"There's not much empirical evidence to support that buybacks are good for shareholders over the long term. Companies do it when times are good. Dividend growth is a much stronger long-term plus for shareholders," said Walsh.

Her main concern going into 2012-2013 is tax code uncertainty, as higher corporate taxes could threaten a dividend strategy.

Walsh's advice to other managers navigating this new landscape? "The most important thing to watch is what companies do and not what they say. A lot of corporate cash on balance sheets is trapped overseas, and the Street is, rightly, very skeptical about how that cash is spent," she said.

Yacktman, however, still sees the value in basic bottom-up analysis when it comes to equities. "The business boils down to what you buy and what you pay for. We favor the left side of the balance sheet, looking to see if companies have the necessary assets to run the business," he said.

In favor of the equity shareholder, Yacktman adds, "I would rather see a company ... buy back their stock, and take advantage of a tax shelter to enhance shareholder's wealth."

Michael Herbst, director of active strategies for Morningstar, put it succinctly: "Whether to invest in stocks, bonds, given today's market of low yields, and high profitability, conventional wisdom can be flipped on its head."