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October's Mutual Fund Red Flags

Three quant funds hurt by market shock.

Bridget B. Hughes, 10/16/2007

Morningstar's fund analysts cover 2,000 mutual funds. Their full analyst reports, including Stewardship Grades, are available in Morningstar Principia Mutual Funds Advanced and Morningstar Advisor Workstation Office Edition.

This article originally appeared in Morningstar FundInvestor, an award-winning newsletter that presents investment strategies and tracks 500 funds.

The dog days of summer?

Uh-uh. Not this year. Sure, it was hot and muggy outside, but the stock market has been anything but slow, stagnant, or mundane. We saw in a matter of two weeks the S&P 500 fall nearly 8% from its high on July 19, 2007, only to regain 4.5% in the next three days. From there it was off 6% a week later. The S&P 500 Index was up nicely in the third quarter, but there was extreme volatility along the way. The Russell 2000 Index has acted similarly, as have other markets around the world.

Of particular concern in volatile markets are quantitative strategies. That's because most quantitative approaches build portfolios based on various trends-both fundamental and technical-and when those trends quickly change, it can take some time for some programs to catch on. The markets adjust faster than they do because it takes a while for the new reality to show up in earnings reports and even analyst estimates of future earnings.

American Century Income & Growth BIGRX
Between July 19 and Aug. 15 this summer, this large-value fund lost 11.75%-nearly 4 percentage points more than the S&P 500 Index. It also suffered more than the average large-cap fund. A healthy slug of financials, including substantive stakes in Citigroup and Washington Mutual, certainly hurt. Over the long haul, the fund has posted mediocre results versus its category peers, though it looks better compared with its benchmark, the S&P 500 Index, and has met its goal of outperforming that bogy in most 12-month periods.

American Century's roots are in quantitative investing, and here the managers emphasize dividend yield as well as earnings stability and some momentum traits, while keeping the portfolio's sector and industry weightings close to those of the S&P 500 Index. The fund has been more volatile than other large-value funds, and its return consistency rating is low, suggesting bigger performance swings. That may be too high a price to pay for returns only marginally better than those of the S&P 500 Index.

Bogle Small Cap Growth BOGLX
This closed small-blend fund was among the hardest-hit quant funds in the 500: It fell 15.4% in the recent sell-off. The quant fund is driven by fundamental data pulled from SEC filings such as 10-Qs. However, even that sort of past historical information can be quickly devalued in a market shock, and that's likely why the fund has performed poorly. We continue to recommend the fund, however, considering manager John Bogle Jr.'s experience with quantitative investing and his good stock-picking over the long haul, thanks in part to his models' emphases on earnings growth and earnings quality. Also, Bogle's is a shareholder-friendly firm.

Bridgeway Aggressive Investors 2 BRAIX, Small-Cap Growth BRSGX, and Small-Cap Value BRSVX
Manager John Montgomery once said that he sometimes has to hold his nose as he's making trades. He's cagey about what goes into his quantitative models, but it's clear that sometimes there's going to be some ugliness, both in the portfolios and in their performance. That's particularly true for Bridgeway Small-Cap Growth and Small-Cap Value, which are intended to be representative of their universes. Bridgeway Aggressive Investors 2 is more flexible when it comes to market cap and sectors, among other things. Small-Cap Value was the worst performer in the recent sell-off, shedding 16.37%-we'd expect that considering its value tendencies.

The funds have historically been more volatile than their peers, so dramatic market moves won't treat these funds kindly. But Montgomery's models have turned out some exceptional returns in various categories, and he's one of the most shareholder-friendly portfolio managers.

Bridget B. Hughes is a senior analyst with Morningstar.

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