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December 2008 Mutual Fund Red Flags

There's been troubling performance at these three funds.

Greg Carlson, 12/30/2008

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.

Warren Buffett once said, "It's only when the tide goes out that you learn who's been swimming naked." That was a metaphor concerning risk-takers, who look great when times are good but are exposed when things get ugly. And that has certainly been true this year. This month, we're taking a look at three funds that like to live on the edge and have been hammered this year as a result. Are they worth owning?

Vanguard Capital Value VCVLX
It's rare to find a Vanguard fund that takes big risks-- most employ relatively tame strategies and allow their low costs to give them a leg up over the long haul. But this large-value fund, which has always been rather bold, received an extra jolt of aggressiveness in June when Peter Higgins took over. Higgins is valuation- sensitive, but he's also a fast trader who made big sector bets at previous charges Dreyfus Premier Midcap Value DMCVX and Dreyfus Small Company Value DSCVX. He posted strong returns at Midcap Value but subpar returns at Small Company Value, and both were extremely volatile during his tenure. Thus far, this fund looks like it'll be a bumpy ride under Higgins, too. He's added some growth-oriented plays to the portfolio, such as Research in Motion RIMM, which have been pounded as the economy has slowed. Meanwhile, the fund's financial holdings have been slammed as well. Going into the third quarter, the fund had a combined 5% of assets in companies that were essentially rendered worthless in September, such as Washington Mutual. All told, the fund has lost a painful 52% for the year to date (including 49% in the past three months alone), one of the worst showings in the category. Higgins may be able to turn this fund around, given his track record, but we'd watch from the sidelines.

Fidelity Pacific Basin FPBFX
The chickens have come home to roost at this fund. Dale Nicholls, who's run it for four years, is more adventurous than most of his already intrepid category peers. He focuses much more heavily on smaller companies than his rivals (the fund's average market capitalization is the lowest in the category), and the fund's stake in less-developed markets is higher than average. Those emphases paid off when times were good, but as investors have fled what they perceive to be shakier companies and markets, the fund's holdings have gone into free-fall. It's declined 61% for the year to date, the worst loss in the category. (The fund's record under Nicholls is now subpar.) Given its immense risks and the misfires here, we don't see much reason to own this fund.

Fidelity Convertible Securities FCVSX
The convertible-bond market has plunged sharply in 2008, in part because hedge funds that use arbitrage strategies involving converts have been forced to liquidate some or all of their holdings. Also, a hefty chunk of converts have sub-investment-grade credit ratings, and investors have fled such securities in the bear market. Thus, the typical fund in this category has lost 37%. However, this fund has been hit even harder--it's down 51% and lags all of its rivals. Manager Tom Soviero (who also runs Fidelity Leveraged Company Stock FLVCX) focuses on converts with a great deal of sensitivity to equities, runs a relatively concentrated portfolio, and bets big on particular sectors. All those risks have come to the fore of late--hefty stakes in energy and materials firms, which juiced the fund's returns after Soviero took the helm here in 2005, have backfired as the economy has slowed. We think the fund remains a worthy holding, but only for investors with strong stomachs. It's also worth noting that this fund has changed managers frequently in the past, so Soviero may not be here for the long haul. 

Greg Carlson is a mutual fund analyst with Morningstar.

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