Know Your Fund Company's Achilles' Heel

Morningstar

Fund companies sometimes move many funds in lock step, for good and bad.

For example, over the summer, PIMCO's bullish bet on long-term inflation-protected securities in a bunch of its funds stung. Interest rates rose while inflation expectations fell, a double whammy for long-term Treasury Inflation-Protected Securities. It wasn't a disaster for PIMCO, but it did take a bite out of a wide swath of its funds.

PIMCO's macro calls, such as this one, are often included in a bunch of PIMCO's bond funds. In addition, PIMCO runs asset-allocation funds that own a number of its bond funds, so it affects them, too. It also can have an impact on stock funds like PIMCO StocksPLUS (PSTKX), where the strategy is to buy index futures and try to add value with a fixed-income portfolio held as collateral against those futures.

The mistimed bet hasn't shaken our faith in PIMCO because it's had more winning bets than losing ones over the years and this isn't really a surprise. PIMCO's TIPS bet isn't nearly as scary as Janus' firmwide Internet bet in 2000, but there's no need to make a firmwide bet into a bet across your own portfolio. These examples illustrate why you should diversify out of even the best fund companies.

How do you diversify a portfolio heavily skewed to one fund company? Let's look at some blind spots or other limits that big fund companies can have, and I'll share some ideas for funds that would make a nice fit.

A PIMCO-Heavy Portfolio
Stock funds are the obvious complement to a PIMCO-laden portfolio, but if you have most of your money in fixed income, consider some non-PIMCO bond funds, too.

Municipal bonds are a small sliver of PIMCO's business, so let's start there. A fund that doesn't make top-down calls but instead focuses on issue selection would make a nice diversifier, so consider a fund like Fidelity Tax-Free Bond (FTABX). You can also lower your costs with the help of a Vanguard fund such as Vanguard Intermediate-Term Tax-Exempt (VWITX). Even taxable bonds might be an area to diversify. On the lower-risk side, I'd consider Dodge & Cox Income (DODIX), which also focuses more on issue selection and less on macro bets.

An American Funds-Heavy Portfolio
Although American Funds has fallen in investors' minds, you can still build a pretty good portfolio with its funds. It runs outstanding foreign- and domestic-equity funds that are dependable and cheap. Don't avoid them if they are in your 401(k).

However, the American Funds multimanager run-a-ton-of-money-in-one-fund model hasn't worked too well for small caps or bonds. The multimanager system doesn't work well in bonds. In addition, they just haven't kept pace with the competition when it comes to bond analytics. In fact, we rate seven bond funds from American, and they all earn Morningstar Analyst Ratings of Neutral. For small caps, American has just one very diffuse world-stock fund that doesn't really have much appeal.

On the bond side, you've got lots of options to diversify your portfolio, but here are three worth a look for no-load and load. On the load side, there's Franklin Federal Intermediate-Term Tax-Free Income (FKITX). Franklin is one of the better muni managers on the load side. It has modest costs and robust resources for doing research.

On the taxable side, let's stay with the Franklin Templeton family and buy the bold border-crossing Templeton Global Bond (TPINX) run by Michael Hasenstab. The strategy is to combine currency and yield plays in order to deliver strong long-term returns. It's got a fair amount of risk, though, so this will work only as a long-term holding. Now, let's dial down the risk by purchasing PIMCO Real Return (PRTNX) for some well-run TIPS exposure.

On the no-load side, we can switch to Harbor Real Return (HARRX) for the same PIMCO strategy and manager. For munis you can use the same ones I mentioned for PIMCO, but consider Fidelity Intermediate Municipal Income (FLTMX) if you want a little less interest-rate risk. Finally, we'll round things out with T. Rowe Price New Income (PRCIX). This intermediate-term bond fund is a typical T. Rowe fund when it comes to caution and diversification. The fund tends to outperform in difficult markets and have more-middling returns when risk is rewarded.

A Fidelity-Heavy Portfolio
You can build a complete portfolio at Fidelity, but it's not quite ideal. Fidelity has some strong equity funds, but also a lot of mediocre ones. Moreover, Fidelity's stock funds tend to run with the pedal to the metal, so that you make a robust return in rallies but often get smacked in sell-offs. Let's consider some more-cautious funds and some focused ones, too, as Fidelity tends to run huge portfolios.

FPA Crescent (FPACX) is the sort of fund you won't find at Fidelity. It's cautious, focused, and even has a smattering of short positions. Steve Romick is a long-tenured manager who figures to stick around--another welcome contrast with Fidelity.

Tweedy, Browne Global Value (TBGVX) is not particularly focused, but it is a solid value fund with a decent amount of smaller-cap stocks that should make for a nice diversifier. Fidelity still has a little work to do on its foreign-equity side.

Longleaf Partners (LLPFX) is a focused value fund worth a look. Yes, it has been through a slump and had some well-publicized spats with shareholdings at Dell and Chesapeake Energy (CHK), but the long-term record is strong and the culture is shareholder-friendly.

Oakmark Select (OAKLX) is another appealing focused fund. Bill Nygren has proved adept at finding great long-term investments. Sometimes he buys a little early, but usually he comes out ahead in the end.

Fidelity has closed its best small-cap funds, so Broadview Opportunity (BVAOX) is worth a look. Rick Lane and his team have built a great long-term record by looking for well-managed companies with good market positions but whose shares are trading at sizable discounts to private market values. As with most focused funds, returns can be pretty lumpy.

A T. Rowe Price-Heavy Portfolio
T. Rowe Price (TROW) is another place I would be pretty comfortable building a complete portfolio. In fact, the two earn our top target-date ratings in part because their depth and consistency are tough to beat. T. Rowe lacks good index funds, however. Naturally, Vanguard Total Stock Market Index (VTSAX) and Vanguard Tax-Managed International (VTMGX) are great ways to lower your costs and cover the whole market.

T. Rowe also has a shortage of great foreign funds. I like Causeway International Value (CIVVX), which is an outstanding pure developed-markets investment with seasoned managers. Artisan Global Value (ARTGX) is a nice focused foreign fund that would appeal in a lineup of more-cautious, diffuse T. Rowe funds. I also like Dodge & Cox Global Stock (DODWX) as a dependable, low-cost, actively managed option that you can buy and hold for a long time.

If you'd like an active asset allocator, Rob Arnott's PIMCO All Asset (PASDX) is worth a look. It's down this year in part because of that firmwide issue at PIMCO this summer, but the long-term record gives reason to keep the faith.

A Vanguard-Heavy Portfolio
Vanguard is great, but sometimes its actively managed funds get watered down by too many managers. The focused funds mentioned above have natural appeal. If you have a couple of broad index funds, then focused funds don't entail as much risk as long as you don't make them huge positions. Funds I already mentioned like Oakmark Select, Longleaf, and FPA Crescent fit the bill.

Akre Focus (AKREX) is a nice mix of caution and aggression as Chuck Akre is a brilliant growth stock investor who will let cash build when the market isn't offering good bargains. Unfortunately, he isn't Vanguarding when it comes to costs.

Vanguard's bond funds tend to go straight down the middle, and that's great, but it means the taxable ones are mostly government-heavy and have interest-rate risk. PIMCO Investment Grade Corporate Bond (PIGIX) is a great way to escape government debt. If you want to get even bolder, PIMCO Unconstrained Bond (PUBDX) has greater flexibility to shelter investors from interest-rate risk and makes a welcome diversifier for a portfolio with bond index funds.

Russel Kinnel has a position in the following securities mentioned above: OAKLX FTABX DODIX.

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