March's Mutual Fund Red Flags

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.

We're noticing some surprising domestic-stock funds with stakes in India. The rapid economic growth has been broadbased, with increased demand for consumer goods from a growing middle-class population, a rising high-tech industry, and focus on improving the country's infrastructure driving a more than 9% economic expansion for the past two years and eye-popping stock market gains of more than 47%.

The handful of U.S. funds with India stakes have benefited from their bet but that could work the other way, too. In fact, there are early signs of problems as a number of recent IPOs in India have been cancelled due to weak demand. So far in 2008, the Indian market is down about 24%.

Janus Contrarian JSVAX
This fund's 16% stake in India stocks is one of the highest for any fund in a domestic-fund category. Manager David Decker has used the fund's flexibility to invest overseas with aplomb in recent years--its annualized three- and five-year returns of more than 20% place it at the top of the large-blend category. Top picks such as ICICI Bank IBN and Reliance Industries have helped push returns to the head of the class (Decker's domestic stock selection has been strong as well). Investing off the beaten path has served investors well over the long term, but the price of admission is higher volatility. The fund's returns bottomed in 2001 and 2002 as many of the speculative holdings faltered, but an increased focus on clean balance sheets and strong cash-flow generation should help it navigate the next market downturn with better success.

Federated Kaufmann KAUFX
This mid-growth fund also has a 16% stake in India stocks. Atypical allocations are nothing new for this fund, however, as the management team led by longtime skippers Hans Utsch and Larry Auriana will let cash build and readily scoop up overseas names (27% of its most recent portfolio). The cash stake has prevented the India stake from hurting performance too badly this year. The Indian market is off about 24% for the year to date, but Federated Kaufmann is off 10%. This wide-ranging portfolio has 19 stocks from India, including Housing Development Finance and DLF Limited, so when India has problems, the fund will have problems.

T. Rowe Price Media and Telecom PRMTX
Manager Henry Ellenbogen has continued this fund's success since taking over for veteran manager Rob Gensler (now at sibling Global Stock) in April 2005. Its 18% annualized gain for the past three years through mid-March is near the top of the specialty-communications category. The fund's 5% stake in India is concentrated on telecom service provider Bharti Airtel (4% of assets). Concentration is nothing new for this fund, but we like that its top-heavy profile is offset with broad sector and global exposure. The fund portfolio includes media and gaming stocks and willingly invests overseas. Ellenbogen's execution has generally been spot-on, but we'd still use this Analyst Pick in small doses.

Davis Financial RPFGX
Investing in India stocks isn't the only way this Analyst Pick stands apart from its specialty-financial peers. Veteran manager Ken Feinberg and newer comanager Charles Cavanaugh also own a handful of nonfinancial stocks such as Sealed Air SEE and Tyco TYC that boast the same traits as their sector picks-topnotch management, predictable growth that compounds earnings for many years, and reasonable stock prices. The fund's combined 5% stake in the State Bank of India and ICICI Bank is a result of the team's patient, company-specific research to find long-term values. The fund's single-digit turnover is evidence of management's commitment to look past short-term market gyrations, so we wouldn't expect it to trim back its stake just because the stocks become overheated in the near term. If the fundamentals hold, these stocks will likely remain in the portfolio for years.

Andrew Gogerty is a mutual-fund analyst with Morningstar.