Benz: 4 Biggest Investing Surprises of 2014

Christine Benz: Jason, great to be here.

Stipp: We had a few surprises this year to choose from. It was a volatile year in some ways, and certainly some things caught us off guard. The first surprise: You say that probably the biggest surprise was bond performance this year.

Benz: That's right. Investors have been on pins and needles about their bond holdings really for several years running. And if you had told me at the outset of 2014 that the long-term government bond would have returned upwards of 20% so far in 2014, I would have been very, very surprised. Very few people were calling for yields to drop further still, but in fact they did. And that had positive effects for all manner of bond funds, especially higher-quality and longer-term bond portfolios performed very, very well during this period.

One thing, too, that I think has probably surprised a lot of observers--me included--is that the Barclays Aggregate Index, which I think a lot of people thought was just going to be a lay-up market benchmark to beat over the next few years, has actually outperformed most active intermediate-term bond funds. Many people thought that its heavy emphasis on government bonds and its meager yield would work against it, but it's really actually been a very nice index to hold if you had fixed-income exposure so far in 2014.

Stipp: And that's important to point out because a lot of active managers have been shorter in their duration because they've also been worried about interest rates rising. So, they also were probably surprised by what we saw.

Benz: They have been shorter, for sure. We've seen that. We've also seen a lot of bond-fund managers emphasizing corporate and other bond types at the expense of government bonds when, in fact, government bonds have had a really nice rally here. Most active funds did not own that much in government bonds.

Stipp: A big surprise here late in the year: falling oil prices and some of the effects of falling oil prices. I don't think anyone really saw that coming right at this time.

Benz: No, no one saw [that coming] as far as I know. And I certainly didn't--the rapidity with which oil prices would fall. You might have expected, I guess, in an environment in which oil prices are falling that energy investment--certainly individual stocks and energy funds--would feel the pain. Maybe value-leaning funds, I might have expected to see some dislocation there, because they tend to invest a little more heavily in the energy sector than more growth-leaning funds.

But one thing that has surprised us--and one of our analysts, Sumit Desai, has been keeping an eye on this--are the knock-on effects of falling oil prices. One thing he's been monitoring specifically is the interplay with the high-yield bond market and oil prices, because energy companies tend to be pretty big issuers of lower-quality bonds and they have been pretty dramatically impacted by falling energy prices. They have translated into falling high-yield bond prices as well. So, even though high-yield bonds were doing pretty well as the year unfolded, just here in the fourth quarter they've incurred some trouble, in part, because of falling oil prices.

Stipp: So, the oil slide certainly causing some issues in some parts of the market, but it could be good news for other parts of the world and other economies.

Benz: That's right. So, one area you might, in fact, look at as a beneficiary of falling energy prices would be emerging markets--countries that tend to be big importers of oil and other energy products. They would, obviously, stand the benefit if, in fact, the prices declined. So, we may see some positive effects for those markets going forward. We've also heard that, even though high-yield bonds are somewhat beleaguered right now, that there could, in fact, be a nice rebound if energy prices come back.

Stipp: And I think after we saw a big rally in 2013, going into the market in 2014, we didn't expect to see the kind of performance that we've actually gotten out of the S&P 500.

Benz: Yeah, we've seen very strong performance from the S&P 500. Here's another index that has been very difficult for active managers to beat. Even large-cap actively managed funds have had a very difficult time beating that very vanilla benchmark. I don't expect the S&P 500 on a going-forward basis to be quite as strong performing relative to actively managed funds. I think, over time, the benefits of being in a good, cheap index fund will add up. You don't typically have years, though, where the S&P 500 is really knocking the cover off the ball relative to active funds as has been the case so far in 2014.

Stipp: But we are seeing some bifurcation, though. We are starting to see some parts of the market behave differently and not in lockstep, which is something we had been seeing for a while.

Benz: That's right. I think, in fact, some people were wondering, "Wow, is this strong trend toward investors buying passive products, is that, in fact, contributing to all equity assets kind of behaving in the same way?" Well, 2014 is here to show us that that's probably not the case--where we've seen a really strong, as you say, bifurcation in terms of performance, where small caps have dramatically underperformed large-cap stocks.

There is a little bit less of a performance gradation when you look across the style spectrum in each market-cap band. There's no clear trend that value has outperformed growth or any such thing. But certainly from large to small, we are seeing a big performance bifurcation. As well as between U.S. and foreign stocks, we are also seeing performance that's quite different for U.S.-focused stock funds versus foreign-stock funds.

Stipp: One of the silver linings of that is it may provide you some opportunities to do some rebalancing or maybe to shift some money into things that haven't done so well because it could be a better time to get some more exposure to those areas.

Benz: I think that's right. This is a time of year when investors often do you their rebalancing in their portfolios. For many investors, rebalancing will call for probably cutting back on equities; but for investors who want to make some changes within their equity piece just to make sure that going forward their performance is as strong as possible, I think they might look at foreign stocks as a potential area to emphasize at the expense of U.S., given that we have seen a pretty big spread in performance between U.S.-focused investments and foreign stocks.

Stipp: Lastly, our surprise list for 2014 would be incomplete if we didn't include the biggest news in the fund world, which is Bill Gross leaving PIMCO for Janus.

Benz: Right. All of our email boxes began blowing up that Friday morning when we got that news. And really, I think you get a piece of fund-related news this big about once every decade. The last one I can remember was probably the fund-trading scandal back in the early '00s. But we really haven't seen as big a piece of news since. I think many people certainly expected Bill Gross to retire now that he's in his 70s, but I think most people--me included--expected him to retire from PIMCO, which was the firm that he built and was so closely associated with.

So, it was surprising to hear of his departure, to hear that he was going to be managing a new fund for Janus. And frankly, in the days and weeks following his departure, I was also surprised at the velocity of outflows from PIMCO Total Return (PTTRX).

I don't usually like to make decisions that quickly if I have investments, especially with funds. You usually have a little bit of time to decide what you're going to do. But a lot of investors voted with their feet very, very quickly. I think they were probably fearful that if redemptions really picked up and a lot of investors decided to leave PIMCO Total Return that that could begin affecting the fund performance. But I was surprised by the speed of the outflows, particularly given that the team that remains at PIMCO Total Return by all accounts and certainly according to our fixed-income fund analyst team, is a pretty worthy one. So, I was surprised that so many investors voted with their feet right out of the box.

Stipp: Well, that's one surprise that our analysts will continue to be watching very closely. It was an eventful year, Christine, but as always, your insights for investors really pay off for them. Thanks for joining me again.

Benz: Thank you, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.