(PUB) Investing 2016

11

November 2016

Morningstar FundInvestor

These Funds Bought Tech, but Underachieved Red Flags | Laura Lallos

who can ride out periods of sharp losses and short- term relative underperformance.

FPA Capital FPPTX averaged a 20 . 8% tech stake over the past three years, which should have given it a big advantage over its typical mid-cap value peer, which held only 10 . 8% here. However, it held even more in energy, 24 . 6% versus 7 . 4% for the category norm. Stock selection within energy confounded the problem, and the managers’ tech picks were not stellar, either, with Veeco Instruments VECO among the top 10 detractors. The fund actually lost an annualized 2 . 7% over the past three years, while its average category peer gained 5 . 2% . In this case, the 10 -year num- bers offer no consolation, with the fund landing in the bottom decile there, too. This uncompromising deep-value approach may still hold promise for patient contrarians. However, lagging performance and some turnover on the management team prompted a rating downgrade to Bronze from Silver a year ago. Berwyn BERWX was also in the red over the past three years, with an annualized 1% loss, while its typical small-blend peer gained 3 . 1% . That’s even though this fund averaged a 23 . 7% stake in technology, com- pared with only 14 . 6% for the category average. That was a plus, but the fund’s other significant over- weighting, basic materials at 11 . 8% , was crushing as commodity prices dropped and its deep-value in- vestments tanked. What’s more, it has a micro-cap tilt, and micro-caps lagged stocks on the larger end of the small-cap spectrum. There is no inherent flaw in the process; the fund’s longer-term numbers are stronger, and it has bounced to the top decile for the year to date. The lesson here is to be aware of the idiosyncrasies that will force the fund out of step at times. K Contact Laura Lallos at laura.lallos@morningstar.com

Investing in technology should have been a sure-fire winner over the past three years. Technology- sector funds outperformed all other specialty- and diversified domestic-equity funds, averaging an 11 . 7% annualized return through Oct. 31 . Over the trailing one-year period, only specialty precious- metal and utilities funds have done better. And yet, some funds with outsized stakes in technology have lagged their Morningstar Category peers consid- erably. We took a look at funds with technology stakes well above their category average that landed in the bottom decile of the category over the three- year period. Is the underperformance understandable or a sign of a potential problem? Touchstone Sands Capital Select Growth PTSGX was the only Morningstar 500 fund in a growth category with both a heavy tech stake and serious underperform- ance. By and large, high-growth tech stocks have been a winning bet over this time, and the more the better. This fund averaged a 35 . 4% stake over the past three years, compared with 23% for the large-cap growth average. However, its annualized three-year return of 2 . 5% over that time is well below the 7% average. Its outsized technology stake was the biggest positive contributor to returns, but that was offset by a 7 . 5% average stake in energy, about twice that of the category norm. (That is now down to a 2 . 2% posi- tion in Schlumberger SLB , in the portfolio for more than a decade.) This recent record illustrates the risk of this concen- trated, quirky growth strategy, but we recently confirmed the fund’s Morningstar Analyst Rating of Silver. Its strong process leads to long-term in- vestments in businesses with strong balance sheets, low debt levels, and strong cash positions, and the fund is in the top decile of the category over the 10 -year period, guided by lead manager Frank Sands Jr. This remains a strong choice for investors

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.