(PUB) Investing 2015

11

Septemb er 2015

Morningstar FundInvestor

We’ve Spotted Some Spikes in Turnover Red Flags | Jeff Holt

to roughly 120 stocks from 400 – 500 stocks. Persaud also increased the fund’s focus on large-cap dividend- paying stocks, ridding the portfolio of most small- and mid-cap holdings. The year 2014 marked the second time in six years that the fund’s turnover ratio spiked. It also skyrocketed to 177% in 2009 , which was Rakers’ first full year at the helm. Management changes have muddled the fund’s identity. Changes in management don’t explain all sudden surges in turnover ratios, though. Longleaf Partners International LLINX experienced more portfolio change than usual in 2014 , and two of this fund’s four comanagers, Mason Hawkins and Staley Cates, have been running the fund since its 1998 inception. The fund’s 54% turnover ratio in 2014 was its highest of the past 10 years. The managers added nine new holdings to a portfolio of only around 20 stocks, and 14 holdings departed. They typically main- tain a steady hand with holdings but sold a couple of companies—Japanese builder Iida and Dutch oil- storage firm Vopak —in the fourth quarter of 2014 that they purchased earlier that year as the stocks were more vulnerable than they expected. In this case, the turnover spike was a result of errors that led management to decide some holdings were not all they were cracked up to be. Stock-picking errors contributed to a downgrade in the fund’s Analyst Rating to Neutral from Bronze in July 2015 . Rising portfolio turnover doesn’t automatically indicate a problem. The turnover ratio for Silver-rated Aston/Fairpointe Mid Cap CHTTX topped 50% in 2014 , more than twice its average during the previous nine calendar years. Lead manager Thyra Zerhusen, who joined the fund’s manager roster in 1999 , and her comanagers found attractive opportunities in basic- materials and niche technology names in the first half of 2014 , taking sizable positions Owens-Corning OC and Teradata TDC . (Both are now top- 10 holdings.) Zerhusen has a history of diving into sectors and industries where she finds attractive opportunities. The 2014 uptick in turnover doesn’t appear to signal a departure from the managers’ time-tested approach. K Contact Jeff Holt at jeff.holt@morningstar.com

An equity fund’s turnover ratio—the percentage of the portfolio’s holdings that have changed during the past year—provides insight into management’s investment approach. For instance, if a manager replaces all the securities in a portfolio in a year, the fund’s 100% turnover ratio suggests that the man- ager generally has a one-year investment horizon for holdings. Low turnover ratios imply longer-term horizons, whereas higher ones indicate more-frequent trading. An uncharacteristic spike in a fund’s turn- over ratio may signal a departure from its existing pro- cess. Let’s take a look at four equity funds whose turnover ratios have risen in recent years and whether or not investors should be alarmed. The turnover ratio for Meridian Growth MERDX , which has a Morningstar Analyst Rating of Bronze, shot up to 96% in 2014 after hovering between 25% and 37% the previous five calendar years. The jump was attributable to a wholesale change in the portfolio management team. Current managers Chad Meade and Brian Schaub took this fund’s helm in September 2013 and instituted an approach that they executed with success for several years at Janus. (They comanaged Janus Triton JATTX from 2006 to 2013 .) This resulted in dramatic changes to the portfolio, such as broadening the portfolio to more than 75 stocks from roughly 55 . The changes even caused the fund to move to the small-growth Morningstar Category from mid-growth. The man- agers’ impressive track record at Janus helped brighten the fund’s prospects. Likewise, a manager change at Neutral-rated Fidelity Dividend Growth FDGFX resulted in a sudden climb in its turnover ratio ( 99% in 2014 compared with 63% to 69% the previous three years). Ramona Persaud took the reins from Fidelity veteran Larry Rakers in January 2014 and slashed the number of holdings

What is Red Flags? Red Flags is designed to alert you to funds’ hidden risks. Such risks can take many forms, including asset bloat, the departure of a solid manager, or a focus on an overhyped asset class. Not every fund featured in Red Flags is a sell, and in fact, some are good long-term holdings. But investors should be prepared for a potentially bumpier ride in the near future.