January's Mutual Fund Red Flags - Morningstar Advisor

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January's Mutual Fund Red Flags

by Dan Lefkovitz | 01-23-07

This article originally appeared in Morningstar FundInvestor, an award-winning newsletter that presents investment strategies and tracks 500 funds.

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 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.

The strength of overseas markets has been one of the great investment stories of recent years. Europe has benefited from a wave of corporate restructurings, mergers and acquisitions, and low interest rates. Emerging markets, especially Latin America, Eastern Europe, and certain Asian markets, have defied gravity. Even Japan has shown signs of life. Meanwhile, the dollar has declined sharply since 2002, especially against the euro and the pound. The European stocks in U.S.-based mutual funds' portfolios have appreciated simply by virtue of being denominated in strong currencies.

Increasingly, portfolio managers of U.S. funds are looking for ideas overseas. Perhaps as a result of foreign outperformance, or maybe just simply to broaden their opportunity set, we're seeing funds in domestic categories, which don't have words like "global" or "worldwide" in their names, venturing into overseas markets.

Foreign exposure won't be a tail wind forever. Just look at the late 1990s, when many believed the U.S. was so ascendant that U.S. investors questioned the value of investing abroad. Plus, the dollar could suddenly strengthen. (Currency movements are notoriously difficult to predict.) Then unhedged foreign holdings would lose value.

Here are some funds in domestic categories that might surprise in their level of foreign, especially emerging-markets, exposure.

American Funds New Economy ANEFX
This large-growth fund, which focuses on stocks in the information- and services-related sectors, has been active overseas. The fund's most recent portfolio had nearly 40% of assets in foreign stocks. That has helped this fund particularly since large-growth U.S. stocks have struggled. Unlike the previous two funds, though, this fund has roughly 10% of assets in emerging markets. Most of the foreign holdings are from Western Europe and Japan. Considering the shop's global research, it's not surprising that American Funds Growth Fund of America AGTHX and Income Fund of America AMECX have between 15% and 20% of assets invested abroad, though their emerging stakes are negligible.

Janus Contrarian JSVAX
This go-anywhere large-blend fund isn't the only domestic Janus fund with lots of foreign exposure. Janus Fund JANSX, Janus Growth & Income JAGIX, Janus Twenty JAVLX, and Janus Orion JORNX all have hefty foreign stakes. But this one is the riskiest. Not only is manager David Decker investing nearly 40% of the portfolio's assets in overseas stocks, but roughly 25% of assets are in emerging markets. Indian stocks, such as Reliance Industries and Tata Motors, are a particular favorite. Decker's India bet has boosted returns over the past few years, as the Indian market has been strong. But India is also notoriously volatile and could be overheated.

CGM Focus CGMFX
This fund is even more focused and freewheeling than Janus Contrarian. Manager Ken Heebner thinks broadly and takes big bets. At last look, more than 40% of the fund's assets were in foreign stocks, and the fund's emerging-markets stake, consisting of stocks from Russia, Brazil, and Mexico, stood at 30%. Of course, foreign exposure is only one of this fund's risks. Heebner is currently holding just 22 stocks and has stashed more than half of portfolio assets in the energy and materials sectors.

Fidelity Low-Priced Stock FLPSX
The percentage of assets in foreign stocks in this gargantuan mid-blend fund has soared in recent years--to over 25% of assets. Investing abroad is a good way for manager Joel Tillinghast to put the fund's huge asset base to work. Other Fidelity funds with large asset bases, including Contrafund FCNTX, Magellan FMAGX, and Small Cap Stock FSLCX, also hunt abroad. The good news is that this fund's emerging stake is between 5% and 10% of assets.

Dan Lefkovitz is an analyst with Morningstar.

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