(PUB) Investing 2016

11

October 2016

Morningstar FundInvestor

Watch Out for Downgrades Red Flags | Laura Lallos

Shiel’s vague process involves big bets on industries and companies that have invited excessive risk without sufficient compensation. Less Compelling Weitz Hickory WEHIX and Weitz Partners Value WPVLX were downgraded to Bronze from Silver in August, as was Weitz Value WVALX in May. These funds have shied away from their contrarian past, taking more of a quality-oriented bent as the managers have loosened the valuation requirements in their process. It’s hard to argue with the prudence of buying quality, but quality is a crowded trade these days, and while this change could result in lower volatility, it does present additional valuation risk. The funds are now less differentiated from peers, and above-average expenses remain a hurdle. Franklin Federal Tax-Free Income FKTIX and Franklin High Yield Tax-Free Income FRHIX are managed by experienced teams and feature low price tags. The buy-hold processes used are sensible and straightfor- ward but haven’t generated a significant advantage relative to rivals in the funds’ respective categories in the past several years. Both funds were downgraded to Bronze from Silver this summer. We took a fresh look at Natixis ASG Global Alterna- tives GAFAX and concluded that poor performance highlighted inherent problems with its process, lead- ing to a downgrade to Neutral from Bronze. The fund uses a quantitative process to replicate the liquid broad market exposures of the hedge fund industry, but it is limited by its reliance on a narrow universe of liquid tradable markets and on monthly data from fragmented hedge fund indexes. Manager Changes Funds can thrive after the departure of even a great manager. MFS Global Equity ’s MWEFX management team won’t be as strong after the upcoming retire- ment of longtime manager David Mannheim, so we lowered its rating to Silver from Gold in July. The fund remains a terrific source of exposure to the world’s blue chips, however. The strategy will stay intact, and Roger Morley, who became a comanager on the fund in 2009 , remains in place. K

Our analysts regularly review Morningstar Analyst Ratings, and sometimes even old favorites end up being downgraded. Ratings changes can serve as a signal to shareholders that it may be time to review the holding. Risk Concerns September saw an unusually dramatic fall from favor when Fairholme FAIRX dropped to Neutral from Silver. Such drops are often precipitated by manager changes, but in this case longtime manager Bruce Berkowitz remains at the helm, employing the charac- teristically bold, idiosyncratic strategy that made his name. Turnover on the team supporting Berkowitz is troublesome, but liquidity concerns drove the down- grade. While the fund still has a sizable cash stake, it has also suffered net outflows every month for more than five years, and the portfolio is highly concen- trated in less liquid positions such as St. Joe JOE . We downgraded Fairholme Focused Income FOCIX late last year after Third Avenue Focused Credit was forced to suspend redemptions, reasoning that Focused Income’s strategy was also ill-suited for an open-end vehicle that must meet daily redemp- tions. That argument can be applied to the Fairholme stock strategy as well: Even shareholders who remain confident in Berkowitz and his picks may be at the mercy of those who leave and force untimely trades. Risk is also the story behind the May downgrade of Morgan Stanley Institutional Growth MSEGX , one of the most volatile funds in the large-growth Morningstar Category, which can make it difficult for shareholders to stay the course. However, it still remains an excellent option in the category for those with the requisite risk tolerance, as its new Analyst Rating of Silver indicates. On the other hand, Fidelity Capital Appreciation FDCAX moved to Neutral from Bronze in April; manager Fergus

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.