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June 2008 Mutual Fund Red Flags

These hot funds might cool off.

Daniel Culloton, 07/01/2008

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.

Winning streaks are exciting but nerve-wracking. The longer they go on, the harder they are to sustain. The following four funds have all enjoyed strong runs in recent years, but they are also pretty volatile. That makes it dangerous to predict that their current streaks will last indefinitely. That doesn't make them sells, but it does mean that you should have realistic expectations for them.

Franklin Small Cap Value FBVAX
Longtime industrial and energy holdings, particularly coal stocks like Consol Energy CNX, have kept this fund near the top of the small-cap value pack with a better than 15% gain for the five years ended May 2008. Manager Bill Lippman is a seasoned, bottom-up investor who likes out-of-favor stocks and hangs on to them for years. The portfolio rarely looks like the category or relevant benchmarks; it owns few technology stocks, and its steel and metal products industries stake is more than six times the size of the Russell 2000 Value Index's. A high-conviction approach like this can be successful but can also lead to bumps. This fund suffered a nearly 24% loss in 1998, for example. Don't be surprised if this fund's sector and industry concentration leave it out of step at times.

Keeley Small Cap Value KSCIX
Manager John L. Keeley Jr.'s specialty is corporate restructurings, including bankruptcies and spinoffs. This fund also owns no technology or telecommunications stocks and has a lot of money in industrial and energy stocks. The fund has ranked in the top fourth of the category in seven of the last 11 calendar years and has lost money in only one of those campaigns (2002). Yet, the past five years have been very good to energy and industrial stocks. If the future is less kind, this mutual fund could enter a slump. The fund's sector predilections have bothered it at times in the past, including November 2007 to January 2008 when it fell 14.6%.

Fidelity Leveraged Company Stock FLVCX
This fund has an interesting manager and strategy but has some big risks as well. Manager Tom Soviero is a high-yield bond-fund manager who buys the attractively valued stocks of companies that issue highyield debt. Soviero also isn't afraid to load up in areas where he sees a lot of opportunities, so the fund also tends to concentrate in certain sectors, such as energy and industrial materials. There's more than sector bets to worry about here, though. The fund also is exposed to debt-heavy companies that are vulnerable in a weak economy and tight credit market, both of which currently prevail. Furthermore, if a company defaults on its debt, stockholders can be left with nothing. Soviero is experienced, and the fund has finished the last seven calendar years in the midcap blend category's top fourth. The current environment, in which defaults have been increasing, is testing this fund's mettle, though. It fell nearly 9% in January 2008, more than 2 percentage points farther than the S&P 500, bounced around quite a bit in February and March, and was flat for the year through April 30.

This fund is like the little girl who had a curl in the middle of her forehead. When it's good, it's very good, but when it's bad, it's horrid. The mercurial Ken Heebner did it again in 2007, posting one of the best returns among domestic-stock funds by betting on energy and industrial stocks such as CNOOC CEO and Potash Corporation of Saskatchewan POT and betting against Countrywide Financial CFC. Heebner has often wowed his investors and peers with his concentrated, rapid-fire, macro-influenced style, but the fund courts considerable risk. He piles into sectors that he likes, ignores or shorts stocks in areas that he doesn't, and bets big on individual positions. Short-term bumps are a given--20% to 30% losses in a three-month period are not uncommon. To invest here, you have to have a lot of confidence in Heebner's ability to make the right quick calls. You'll also need tolerance for frequent jolts.

Daniel Culloton is senior fund analyst with Morningstar. 


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