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October 2008 Mutual Fund Red Flags

Cooling energy prices could be hard on these funds.

Gregg Wolper, 10/21/2008

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.

The vast financial rescue operation being undertaken by the U.S. government authorities, in conjunction with officials around the world, is designed to head off an immediate crisis in the global financial structure, not to rev up the economy. With housing prices still weak, unemployment rising, measures of industrial production falling, and confidence shaken, it's likely the economy won't be robust for quite some time.

With that in mind, we thought we'd put the spotlight on several funds with hefty amounts of their portfolios in companies from the industrial-materials sector. Don't get us wrong-these are fine funds. They may well be excellent holdings over the long run. This is intended to alert you that, unless these funds' portfolios change drastically, they could be facing head winds for a while.

Delafield Fund DEFIX
This is a consistently stong fund that simply hasn't attracted much attention over the years. Despite a nearly 15-year record of success-with managers Dennis Delafield and Vincent Sellecchia in charge throughout-the fund has only about $700 million in assets. It's been holding up relatively well during the downturn; having lost just 8% for the trailing 12 months through Sept. 19, it's ahead of nearly all other mid-value funds. But it has a large industrial materials weighting-in fact, at midyear, it had roughly half its portfolio in such stocks. That's not performance-chasing: These managers have extensive knowledge in that field, and their weighting in that area has been large for years. That could slow the fund down if the global economy goes in the tank, though the managers' tendency to hold a decent-size cash
stake could help provide a cushion.

Mairs & Power Growth MPGFX
Just like Delafield Fund, Mairs & Power Growth has demonstrated its ability for many years without attracting a lot of attention, though it does have more than $2 billion in its coffers now. It has a quirky mandate: It invests only in the region close to its Minnesota home. While having such a limited menu could hold back lesser investors, this fund's managers have achieved excellent results over the years. Partly as a result of its Great Lakes focus, however, it is heavy in the industrial-materials sector, and an extended economic slump could hit it more than rival funds without that overweighting. That's not a given; so far, it has been more resilient than most rivals during the stock market slide, but the risk is there with an industrial-materials stake more than twice the large-blend average.

Royce Value RYVFX
The managers and analysts at the Royce fund shop certainly know their small stocks, having run them-quite well-for decades. And as with the other funds on this list, we have confidence that the managers will steer this fund successfully over the long term as they have since its 2001 inception. They aren't trendhoppers, having slowly and steadily built their industrial-materials stake-now about twice the small-blend average. Those companies, along with a nice chunk of energy stocks, have helped the fund achieve its solid results in recent years. But both could hurt the fund, too, if the global growth that helped provide the demand that boosted both sectors goes into an extended slowdown-or decline.

Gregg Wolper is a senior analyst with Morningstar.

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