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September 2008 Mutual Fund Red Flags

Cooling energy prices could be hard on these funds.

Marta Norton, 09/16/2008

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 energy sector has had a long run, but it might be a little long in the tooth. The collision of low supply and spiking emerging-markets demand has made it one of the top-performing sleeves of the market for the past several years. Any fund with either the foresight or the mandate to invest in the sector has reaped market-topping gains. In five of the last eight years, for example, natural-resources funds have landed in the top three of their diversified-fund and specialty-fund category peers.

The question now is: Is it over? In July and August, oil and other commodities sold in response to slackening demand. Some managers had already started paring back. Bob Baker and team at Van Kampen Comstock ACSTX sold the fund's last energy stock in 2007 and have resolutely said that the sector is extremely overvalued ever since. Meanwhile, Bruce Berkowitz and company at Fairholme FAIRX sliced that fund's outsized stake in the sector early this summer, citing increased commodity prices, which would slow demand and increase supply.

A bout of volatility and a handful of good managers taking money off the table aren't reasons on their own to say that the rally is over: Stocks often fluctuate for reasons other than fundamental concerns, and plenty of talented managers claim that the sector has more room to climb. They do serve as reminders that the sector doesn't just go up, however. If the party is over, here are a few funds that will have a hangover.

Fidelity Independence FDFFX
This large-growth fund's 37% energy stake stems from manager Bob Bertelson's belief that constrained supplies and demand from emerging markets will continue to push energy prices higher. The energy play isn't a new bet for Bertelson, who has steadily increased the fund's weighting in the sector since his late-2006 arrival, but he isn't early to the game, either, having still added to the fund's exposure there in recent months. Add the fund's slug of energy stocks to its 42% industrial-materials stake, and this fund has significant commodity price risk. At his previous charge, Fidelity Aggressive Growth FDEGX, Bertelson posted poor relative and absolute returns during his 2000-02 tenure.PAGEBREAK

Legg Mason Partners Aggressive Growth SHRAX
Richie Freeman has managed the large-growth fund since its 1983 inception and has made plenty of good calls over the years. Freeman sticks with fastgrowing stocks for the long haul, which tends to prevent the fund from chasing current trends. Nevertheless, with nearly 30% of the fund's assets in energy--half of which he added since the start of 2007--Freeman is in the thick of the market's current craze. It has cost the fund recently and will certainly be a thorn in its side if the energy sector continues to slow. A limited stake in industrial-materials stocks, which are also linked to commodities, eases some of our concern, however. Avoiding most of that sector limits the damage from commodity prices.

We're big fans of manager Bob Rodriguez, who has made a number of savvy calls here over the years. However, we'd be remiss not to point out that the closed fund's mostly cash and energy portfolio (it has 41% of its assets in cash and 30% of its assets in energy stocks) carries its own set of risks. If the energy bet goes against the fund, its cash stake will cushion its losses. However, if the rest of the market rallies, possibly due to a significant energy correction, the fund's cash stake will hold it back and its energy stake will drag it down.

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