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Harbor International Focuses on the Long Term

The Gold-rated fund is experiencing withdrawals amid mediocre near-term performance, but it's still a formidable competitor.

Kevin McDevitt, CFA, 12/04/2016

Harbor International's results have been below its historical standard, but it is still a formidable competitor. The fund retains its Morningstar Analyst Rating of Gold.

This fund is experiencing the most severe withdrawals in its history, but they haven't been terribly disruptive. Amid volatility and mediocre results, investors have pulled an estimated $9.5 billion since September 2014, representing nearly 18% of the fund's beginning assets. But, even though the fund typically keeps just 3% or so of assets in cash, it has easily met redemptions, given that the bulk of its holdings are highly liquid large-cap companies. The portfolio's $45.9 billion average market cap is nearly $20 billion greater than that of the MSCI ACWI Ex-USA Index's.

Fleeing investors may be reacting to the fund's subpar 4.2% annualized five-year return, which trails its typical foreign large-blend Morningstar Category peer by 0.46 percentage points through October 2016, although the fund beat its index by 0.59 percentage points during that stretch. It may also reflect lingering concern about the current team since founding manager Hakan Castegren's death in October 2010.

The fund owned the best long-term foreign-stock record during Castegren's tenure (1987-2010), but it should be noted that all three of the current managers contributed to those results. Jim LaTorre became his director of research in 1993. Howard Appleby and Jean-Francois Ducrest had both worked with Castegren for years as sell-side analysts before joining Northern Cross in 2002.

Plus, the fund has outperformed during the current team's tenure, albeit by smaller margins than in the past. Since Castegren's passing in early October 2010, the fund has edged its average peer and the index through October 2016, gaining 3.62% annualized versus 3.47% for the category average and the benchmark’s 2.72%. The fund has also beaten both bogies since the three current managers were named in February 2009, returning 9.3% versus 8.5% for the index and 8.2% for the category average.

Overall, this team is holding its own.

Process Pillar: Positive | Kevin McDevitt, CFA 11/28/2016 
This fund has generated exceptional results by ignoring short-term volatility and focusing on the long term. These are investment cliches, but here they are true competitive advantages and earn the fund a Positive Process rating.

Management looks for long-term catalysts that may not materialize for three to five years, opening it up to a broad range of opportunities. Rather than spending time trying to guess a company's near-term earnings, the team looks for structural shifts that will affect industry pricing power and competitive advantages, which drive profits over the longer run. The investment team monitors about 300-350 companies that it deems high-quality based on enduring competitive advantages and that have the potential for margin improvement. The team will often spend years getting to know a company and its management before buying shares.

This long-term focus keeps trading to a minimum. The fund's annual turnover is usually below 20%, implying an average holding period of five years or more. While the team pays attention to valuation, it is a secondary consideration. The team would rather pay a fair price for a high-quality company than a low price for a poor one. As a result, the portfolio's average price multiples are often slightly above the foreign large-blend category average. Sell decisions are more often driven by changes in a company's competitive strength than by its valuation.

This fund has substantially reduced commodity exposure in recent years. Believing that demand from China and other emerging markets would drive prices, the fund built heavy positions in energy and materials in 2010. In recent years, the fund has reduced its energy weighting to just 2.9% of assets as of September 2016, well below the MSCI ACWI ex USA Index's 6.8% weighting. The fund's materials stake has fallen to 4.3%, well below the index's 7.7% and far smaller than its 14.7% September 2012 stake.

The team has also reduced its stake in emerging markets to just 5.7% of assets versus 16.9% for the index. Recall that the fund's emerging-markets stake has at times been close to 20% and hit 15.7% in December 2009. The team believes that few emerging-markets companies, outside of several in Colombia, look attractive relative to their currencies.

The team tends to focus on companies with long-term competitive advantages. It has long maintained an overweighting in consumer staples stocks such as Nestle and Diageo DEO, which own strong global brands. It also has big overweightings in consumer discretionary stocks (especially casinos), as well as pharmaceutical and biotech companies. Since few telecom and utilities companies have competitive advantages of any kind, they rarely appear in the portfolio. There are also few tech companies, as the team believes competitive advantages in this sector are fleeting.

Performance Pillar: Positive | 10/06/2014  
This fund's long-term returns are second to none, earning it a positive Performance rating. But it has been a volatile performer. The fund's 10-year Morningstar Risk rating is one of the foreign large-blend category's highest, which has coincided with mixed bear-market results.

The volatility stems in part from management's occasional willingness to embrace emerging markets and, more recently, tolerating stocks trading at above-average price multiples. Its emerging-markets stake has at times been 20% or so of assets, which is well above the foreign large-blend average of 5%. (As of September 2016, the fund had just 5.8% in emerging markets.) However, the fund has sometimes held up better than most peers during bear markets. Its calendar-year returns landed in or near the category's top-quartile during the 2000-02 bear market. Although the fund took a beating during 2008's crash in absolute terms, it was no worse than average.

The sell-off in late 2011 was another reminder of how volatile the fund can be. It fell 22.8% during 2011's third quarter versus a 20.9% drop for its average peer--overweightings in emerging markets, materials, and financials hurt as global markets sold off. Yet the fund still finished 2011 in the category's top 20%. During the 2015-16 bear market, the fund’s 25.7% peak-to-trough (May 15, 2015-Feb. 11, 2016) drop lagged the index by 1.1 percentage points.

People Pillar: Positive | Kevin McDevitt, CFA 11/28/2016  
This team has a solid trio of managers following two losses. Former lead manager Hakan Castegren died in October 2010. While Castegren's passing was certainly a loss, the fund was prepared for the transition. Although the remaining comanagers were only listed on the fund in February 2009, they had worked with Castegren for years prior to that. Comanager Jim LaTorre became the team's director of research in 1993. Howard Appleby and Jean-Francois Ducrest had both worked with Castegren for years as sell-side analysts before joining Northern Cross in 2002. The team dealt with another departure when Ted Wendell stepped down in June 2014. But the team had been preparing for his retirement for years.

Since the team shares research duties, it is easy to shuffle assignments. The team's long-term orientation creates a culture conducive to deep thinking. The comanagers are all generalists, rather than dividing along industry or sector lines. The team's interests are well-aligned with fundholders', as all of the comanagers own stakes in the fund worth more than $1 million. The fund earns a Positive People rating.

Moreover, the team has added analysts. It hired Scott Babka from Morgan Stanley as an analyst in 2010. He was then named research director in 2012. Hai Gao was hired in 2012, although he left in early 2016 for personal reasons. Adam Feldman joined the team in March 2014, with David Lerner following in early 2016.

Parent Pillar: Positive | 10/06/2014 
Harbor Capital Advisors, which managed roughly $91 billion in assets as of June 30, 2014, is known for hiring best-in-class subadvisors to run its funds. Harbor is a wholly owned subsidiary of Dutch asset manager Robeco Groep N.V. The firm has remained hands-off as a parent since first acquiring Harbor in 2001, but a recent change in ownership at Robeco does bear watching: In mid-2013, Robeco was sold by Netherlands-based Rabobank to Japanese financial-services firm ORIX, but signs indicate that this change in ownership will have little to no impact on Harbor's operations.

Harbor will continue to select and monitor managers on its own terms. (It does not use any Robeco managers, for instance.) A 10-person investment team uses a thorough evaluation process, favoring managers with consistent risk-adjusted performance and repeatable strategies. Subadvisor changes are rare, as evidenced by an average manager tenure of 7.1 years; when they occur they are due to reasons beyond short-term performance. Managers' interests also appear to be aligned with shareholders' via strong manager investment in the mutual funds they run.

The firm also offers access to topnotch managers at prices cheaper than are available elsewhere. For example, Harbor Real Return HARRX has a 0.59% expense ratio, but a comparable share class of the fund it is modeled on, PIMCO Real Return PRRDX, charges 0.85%.

Price Pillar: Positive | Kevin McDevitt, CFA 11/28/2016 
The fund's Institutional share class, which contains most of the assets, sports a below-average 0.74% expense ratio, which is well below the 0.93% peer median. This earns the fund a Positive Price rating. (The Investor share class has a 1.11% expense ratio, and Morningstar rates its Fee Level as Average.) Shareholders benefit from a modest price break as assets grow. The advisory fee is 0.75% for the first $12 billion under management and 0.65% for assets above that threshold. The fund's low turnover also keeps trading costs low, with brokerage commissions of just 0.04% of average net assets in 2015 versus 0.14% for the foreign large-blend Morningstar Category average.

 

Kevin McDevitt is an Editorial Director with Morningstar.

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