Morningstar advisers grade funds to build a diversified portfolio, allocation to alternatives now 8%

Date: Thursday, July 3, 2008
Author: Shefali Anand, WSJ.com

At Morningstar Investment Services, analysts give "grade point averages" to mutual funds that they consider for their recommended portfolios. The averages are based on a fund's investment process, performance, expense ratio, the skill and shareholder-friendliness of its management, and size.

Funds from boutique investment-management firms tend to be well-represented in Morningstar's portfolios as a result. The company says such funds tend to score well for their investment discipline, for such shareholder-friendly practices as barring new investors when the fund becomes too big and unwieldy, and for having managers who invest their own money alongside that of shareholders.

Using such criteria, Morningstar says, gives its investment team the confidence to allocate large chunks of a portfolio to funds that pass its tests with flying colors.

In this column, we feature model portfolios from financial advisers who invest in mutual funds and exchange-traded funds. Morningstar Inc. long has been known for research on mutual funds. It launched its Morningstar Investment Services unit in 2001 and currently manages client assets for about 1,500 financial advisers. The unit had just over $2 billion under management as of March 31.

Here, the investment team shares a "growth" portfolio, meant for investors with a high tolerance for risk. The portfolio returned an average 9.3% a year over the three years ended May 31, and 8% a year since its inception on Oct. 31, 2001. The portfolio has a portfolio-weighted expense ratio of 0.96% of assets.

U.S. STOCKS: On paper, the portfolio has a 63% allocation to funds that are primarily U.S.-stock oriented. But by analyzing each fund's holdings and stripping out the foreign stocks, the team says the U.S. piece falls to about 55%. Using the same weighting, the portfolio has a 37% allocation to large-company U.S. stocks, 13% to midsize companies and 4% to small companies.

The largest single recommendation in the portfolio is a 20% allocation to MainStay ICAP Select Equity Fund. The size of the bet on the MainStay fund, part of the lineup of New York Life Investment Management, reflects Morningstar's approach of investing big in funds in which it has a lot of confidence.

"If you like a manager, why do you want to water it down too much?" says Kunal Kapoor, chief investment officer for Morningstar Investment Services. The MainStay fund buys large stocks trading at prices its managers consider inexpensive, and its two managers have more than $1 million of their own money invested.

"We look for fund managers who eat their own cooking," says William Harding, the unit's director of research.

Another large-cap "value" fund in the portfolio is Cambiar Opportunity, at 15%; it looks for stocks with a one- to two-year horizon for reaching designated price targets. The portfolio contains two funds that focus on large, fast-growing companies. At 9% is Legg Mason Growth Trust, whose manager, Robert Hagstrom, aims for growth stocks selling below his estimation of their true value. At 8% is Calamos Growth, which Mr. Harding says benefits from smart analysis of companies' balance sheets and credit-worthiness.

Janus Mid Cap Value fund, sub-advised by Chicago firm Perkins, Wolf, McDonnell & Co., has a 5% allocation, and small-cap Baron Growth and Diamond Hill Small Cap funds each have 3% spots. Diamond Hill's managers look for inexpensives stocks and will hold cash if they don't find any.

The Morningstar team began reducing the small-company exposure in 2004, believing these shares had become too expensive after a good run. If they continue to lose ground in the downturn, Mr. Kapoor says, Morningstar might add more exposure in the next six to 12 months.

FOREIGN STOCKS: Thanks to overseas stocks in U.S. stock funds, the foreign-stock exposure is about 20%, with Artisan International and Dodge & Cox International Stock funds each represented at 7%. While the Dodge & Cox fund looks for inexpensive stocks, the Artisan fund looks for more growth-oriented ones. "We think they work well together," Mr. Kapoor says.

The team doesn't make a separate allocation to developing-country stocks. "We tend to invest with managers who have a lot of flexibility in where they can invest," he says.

BONDS AND CASH: The portfolio has a 3% allocation to cash. One-third of that is in a money-market fund; the rest is represented by the cash holdings of other mutual funds the portfolio holds. The bond allocation totals 14%, split between Metropolitan West Total Return Bond, at 9%, and Loomis Sayles Bond Fund, at 5%. The Metropolitan fund focuses on high-quality U.S. intermediate-term bonds, while the Loomis Sayles fund has latitude to invest in many types of bonds, including those with low credit ratings and those from other countries.

Starting in early 2005, the team reduced its exposure to high-yield bond funds and eventually eliminated them, because they weren't delivering high enough returns to compensate for the risk. As these bonds have fallen in price in the market downturn, the team is looking for possible buys.

ALTERNATIVE INVESTMENTS: The allocation to alternative investments is 8%. The team likes these funds because they can reduce volatility without giving up too much potential return; the allocation to this category runs higher in portfolios for more-conservative investors.

The team considers commodities part of the alternative bucket, but isn't currently using a dedicated commodities fund in the portfolio described here. Exposure to energy stocks comes through investments held by funds like Cambiar Opportunity and Diamond Hill Small Cap. Mr. Harding notes that commodities have run up a lot in recent years. If there is a price pullback, they would consider adding a dedicated fund.

Four percent of the portfolio is in Third Avenue Real Estate Value, which has flexibility to invest globally and in various real-estate vehicles. The remaining 4% is in Diamond Hill Long-Short Fund. The team likes the fund's value-oriented approach to buying stocks and thinks it is smart in identifying expensive stocks for the bearish bets.

The Morningstar team has used more alternative investments in recent years because mutual-fund companies they respect have launched such products. Individuals need to be cautious when choosing such funds because there are many "pretenders" that don't deliver on their goals, Mr. Harding says. For instance, he says returns for "130/30" funds are tied to the fate of the broad market, and investors are often better off in a regular fund. The 130 means the fund makes bullish bets on stocks equal to 130% of its assets, and bearish bets equal to 30%.