(PUB) Investing 2016

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March 201 6

Morningstar FundInvestor

Beware of Rising Volatility Red Flags | Laura Lallos

fund’s increased volatility, explains the recent down- grade of its Analyst Rating to Neutral from Bronze.

First Eagle Fund of America FEAFX The recent surge in volatility owes partly to the fund’s sector biases, with an overweighting in basic mate- rials that is among the largest in the mid-blend Morningstar Category. Some of its tech picks have had sharp losses as well. However, we are still positive on the fund’s process, which has led to moderate volatility over the long term. While we downgraded the fund to Bronze from Silver, that owes to problems at First Eagle itself, stemming from improper use of fund assets for marketing and distribution costs, as well as a pending acquisition by two private equity firms. Harbor Capital Appreciation HACAX This fund showed its upside volatility with one of the best showings in the large-growth category last year, owing to high-priced, high-growth names such as Amazon and Facebook FB —a focus that is driving above-average losses in 2016 . We remain confident in Sig Segalas, who’s run the fund for 25 years, and the rest of the growth team at Jennison Associates. These are both concentrated funds, particularly the Select version, with fewer than 30 holdings. The downside risk of such an approach was apparent in both funds’ lagging returns during the past year. We have concerns about changes on the manage- ment and analyst teams, which are a particular risk for a concentrated, distinctive strategy. Both were downgraded to Neutral from Bronze in 2015 . Century Small Cap Select CSMVX This fund had a good year in 2015 for a small-growth strategy, ending the year in the black. Its losses for the year to date aren’t extreme for the category, either. While the fund’s long-term risk profile isn’t out of line with the category norm, a concentrated portfolio with pronounced sector bents is bound to be bumpy. When we last rated the fund in 2014 , our primary concerns were lackluster performance and changes to the investment team, not volatility. K Contact Laura Lallos at laura.lallos@morningstar.com Mainstay ICAP Equity ICAEX and Mainstay ICAP Select Equity ICSLX

Concerned that your stock funds seem much more volatile lately? You aren’t alone: Vanguard 500 Index ’s VFIAX one-year standard deviation was at 14 . 28 at the end of January, compared with 10 . 93 for the three-year period, and most diversified U.S. equity funds show a similar pattern. As observed in the July 2015 FundInvestor cover story, market vola- tility declined after the financial crisis, but the current three-year numbers may be the anomaly: Most of the broad U.S. stock funds in the Morningstar 500 had 10 -year standard deviations on par with or even higher than the current one-year figures— Vanguard 500 Index’s 10 -year figure is 15 . 15 . In other words, this recent surge in volatility probably doesn’t signal a dramatic departure from established strategies. There were a handful of funds, however, with one-year standard deviations significantly higher than their 10 - year figures. That could signal a change, perhaps for the worse. One of those is Sequoia SEQUX . As has already been discussed in a recent Red Flags, its enor- mous stake in controversial Valeant Pharmaceuticals VRX is the culprit. That fund is not appropriate for shareholders who can’t handle such stances, though we continue to give it a Morningstar Analyst Rating of Gold. Below is a look into six more funds that have had notable increases in volatility during the past year. T. Rowe Price New America Growth PRWAX This large-growth fund’s recent surge in volatility is partly explained by the nearly 10% stake in Amazon.com AMZN held by manager Dan Martino at year-end. That was to the fund’s advantage in 2015 , but not in early 2016 . Martino is leaving the fund on April 1 , and new manager Justin White expects to have more of a valuation focus that would probably have pre- cluded such a large stake in a pricey name. White is an experienced analyst, but this is his first stint as a portfolio manager, and this manager change, not the

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.