(PUB) Investing 2016

11

June 2016

Morningstar FundInvestor

Funds Vulnerable to a Growth Meltdown Red Flags | Susan Wasserman

of Bronze, since Baker took over in July 2009 have been rewarded—its annualized 17 . 5% return since then through May 2016 tops the typical large-growth peer by roughly 4% . But the fund’s man- date ensures that it will always have big bets on tech and healthcare. Touchstone Sands Capital Select Growth PTSGX stashes nearly 40% of assets in technology stocks and 30% in healthcare stocks. Apple and Microsoft MSFT have not been in the portfolio since 2013 and 2005 , respectively, but the fund has still been hit hard by the likes of Baidu BIDU and LinkedIn LNKD for the year to date through April 2016 . Healthcare names like Alexion ALXN and Regeneron REGN have also been pain points in the fund, losing double digits during the same time period. This relatively concentrated fund holds around 30 companies, so any single position has a meaningful impact on overall performance. The fund has outpaced the Russell 1000 Growth bench- mark and the typical large-growth peer since its inception in 2000 , but that has come with higher levels of risk, as measured by standard deviation. This Bronze-rated fund works for those with a healthy tolerance for risk, but investors should know that with healthy stakes in technology and healthcare, the fund is susceptible to periods of underperformance. At the other end of the market-cap spectrum, Brown Capital Management Small Company BCSIX allo- cates nearly 50% of assets to small-cap technology stocks and 35% of assets to small-cap healthcare stocks. The Russell 2000 Growth Index, on the other hand, is made up of 25% technology stocks and 28% healthcare stocks. Tyler Technologies TYL and Incyte INCY , which had banner years in 2015 , have skidded for the year to date, contributing to the fund’s 0 . 3% loss through May 2016 . The manage- ment team’s focus on high-quality names across sectors has helped the fund outpace peers and the index over the long term on both a total-return and risk-ad- justed return basis, earning the fund a Gold rating. But the fund’s rocky start to 2016 shows that it isn’t insulated from market turbulence. K Contact Susan Wasserman at susan.wasserman@morningstar.com

Since the start of the bull market in early 2009 through December 2015 , technology and healthcare stocks helped fuel the typical growth fund’s edge over blend and value funds. The Morningstar Healthcare Sector Index and the Morningstar Technology Sector Index returned 22 . 1% and 21 . 4% , respectively, compared with the S & P 500 ’s return of 20 . 0% during the same period. But 2016 has shaken things up: Technology and healthcare stocks are down for the year to date, with some big names posting losses for the first time in years. Not surprisingly, funds with outsize stakes to these sectors have also been hit hard. I found three Morningstar Medalist funds with at least two thirds of their portfolios in technology and healthcare stocks. (Sector funds are excluded from this short list.) Each fund posts strong long-term records, but investors should keep in mind that large sector concentrations will lead to rough patches in performance. Fidelity OTC FOCPX stands out from its typical large-growth peer because of its large technology stake. The fund benchmarks itself to the Nasdaq Composite Index and allocates roughly 50% of assets to tech stocks and another 20% to healthcare stocks. Even within healthcare, portfolio manager Gavin Baker allocates a large chunk to biotech companies. Apple AAPL , Alphabet GOOGL , Athenahealth ATHN , and Biogen BIIB consistently land among the fund’s top holdings, and they have been nice tailwinds to performance during the past five years. But for the year to date through May 2016 , many of these same names have been big detractors, contributing to the fund’s 3 . 9% loss during the same time period. This isn’t the fund’s first battering: It had a rough start in 2014 , but that was primarily due to consumer discretionary picks. This recent bout of underperformance underscores the fund’s sector concentration risk. Investors who have been in this fund, which has a Morningstar Analyst Rating

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.