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By Russel Kinnel and Christine Benz | 12-20-2017 12:00 AM

3 Key Themes for Investors in 2018

Russ Kinnel says investors shouldn't give up on small value funds and shares his picks in the category.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Small-value stocks have turned in relatively weak performance so far in 2017. But Russ Kinnel, director of manager research, thinks that investors shouldn't give up on the category. He is here to discuss that and other key investment themes for 2018.

Russ, thanks for being here.

Russ Kinnel: Happy to be here.

Benz: Russ, in your latest issue of FundInvestor you talk about some of the key themes that investors should have on their radars for (2018). Before we get into small value, I want to spend more time on that one, let's talk about the other two, inflation protection as well as dividends. Why inflation protection, for one thing? No one cares about inflation right now.

Kinnel: That's right. Inflation has been more or less dead the last seven or eight years. I think it's worth paying attention to the tax plan that's about to be passed. It is estimated to add $1 trillion to the federal deficit. Obviously, a very inflationary move. Essentially you are adding a lot of stimulus at a time when the economy is already going strong. Any way you slice it, there's significant chance that inflation kicks up.

We are getting a new chairman of the Fed. We don't know what the new chairman will do in response to that, but I think it makes sense to have some protection in light of that. That might mean TIPS funds, again, not an exciting area to invest, but I think it makes sense to have some inflation protection there. You might want some commodities exposure. It's been a terrible place to invest the last few years. I wouldn't recommend it a lot, but I still think, again, if you have, particularly, if you have a bond-heavy portfolio, it makes sense to have some inflation protection.

Benz: And by TIPS you mean Treasury Inflation Protected Securities.

Kinnel: That's right.

Benz: Dividends, another theme that you think investors should keep an eye on. Why?

Kinnel: That's right. Admittedly, dividends is a long-playing theme of the last decade really. But again, this tax plan is really benefiting corporations. Analysts expect a lot of that money that the corporations are getting will then flow through in the form of dividends. Look for equity income funds or other funds that invest in companies that pay dividends. A lot of the value, a lot of large-cap, either blend or value funds, could well benefit. Dividend growth funds, I think, are another good idea as well.

Benz: Now, small value, I mentioned is another of your themes. What's the case for small value? In 2017, it did not perform as well as the broad market or certainly not as well as categories like large-cap growth. But you think investors shouldn't give up on it.

Kinnel: That's right. And part of the reason is because it's underperformed significantly.

Benz: Poor relative performance, yeah.

Kinnel: Historically, that's a good thing. It 1999, it did much worse than large growth and then came back for a long-running stretch of outperformance versus large growth. It's an area that tends not to excite because they are kind of boring little companies, insurance companies, makers of widgets and things. We don't get excited about that. When there's interesting things like what's going on in Amazon and Facebook going on, we forget about them. They are very steady businesses. A lot of the funds that invest there are actually fairly low-risk, low-volatile. You are getting some diversification and some lower volatility in many of these funds, not all of the small value funds. To me, that gives it a lot of appeal, and I think you don't want to neglect it. At a minimum, you might want to at least rebalance back to what you had dedicated to small value a year or two ago.

Benz: Just to kind of provide some context, this is not a category that you want to be, like, 20% of your equity portfolio. You'd probably want to be a little more modest in terms of your exposure.

Kinnel: That's right. I don't think of it as a core area like a large-cap U.S. But I think it's an area worth investing in.

Benz: You brought a short list of funds that you like. One is Royce Special Equity. It's a fund that has been closed at various points in time, currently open to new investors. Let's talk about why you like it.

Kinnel: That's right. If you've been paying attention to what I've been picking, Royce Special Equity is a longtime favorite. I just think Charlie Dreifus is a great investor. He really pays attention to accounting and that attention, that level of detail often comes through in having fewer blow-ups. It gives the fund really good downside protection. His strategy has always worked well in bear markets. It's one where you tend to do OK in rallies. The last few years haven't been exciting. But in the down markets it really pays off. We rate this fund Silver. It's a really good fund.

We are looking at a manager transition somewhere down the line, because Charlie is not the youngest manager out there. Steve McBoyle has been named his successor and we are pretty confident in him, too. A really good fund. I think a nice fund that really is a purist when it comes to value.

Benz: American Beacon Small Cap Value, it's not a household name. What is that fund and why do you like it?

Kinnel: That's right. What American Beacon does is they go out and find multiple subadvisors in the value strategies. In this case, they have got a number of solid subadvisors running this fund, so Hotchkis and Wiley, Barrow, Hanley and others are contributing to this fund. When you have that many subadvisors, you have a fairly diffuse portfolio. This is not going to be an exciting portfolio, but it's going to be a really steady portfolio. I think, if that's what you want; if you want something steady, this is a nice opportunity with American Beacon.

Benz: Finally, DFA fields various small cap value products. Let's talk about one of the ones that you like in that space.

Kinnel: Sure. They have got, as you say, a few small value funds. I think they are all really good. DFA Targeted Value is one that's a little wider ranging. It goes from micro into mid. It really depends on what fits your portfolio the best. But again, as the classic DFA emphasis on low price/book, but also with DFA's latest wrinkle from a few years ago of profitability, again, this is a fund that is going to be kind of pure exposure to value names and so, tends to do really well. It's priced a little above your typical index fund but well below most active funds. DFA is very good at trading small caps. They do so opportunistically, which means they tend to take advantage of bid-ask spreads and that can add a little value as well. It's really solid package. We rate it Gold.

Benz: Russ, always great to hear your insights. Thank you for being here.

Kinnel: You're welcome.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.

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