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How Mutual Fund Portfolios Can Fool You

Why it's worth looking beyond the names and numbers.

Gregg Wolper, 03/20/2007

Advances in technology have greatly eased the task of mutual fund investing. You can get up-to-date information on just about any fund, often including monthly or quarterly manager commentaries, manager biographies, and full portfolios, simply by clicking on the fund company's Web site. That sure beats waiting six months for the next bare-bones shareholder document to arrive in the mail. Furthermore, technology enables researchers such as Morningstar to use statistical analysis to examine fund portfolios and thus determine, for example, whether a fund that claims to be small growth really is small growth.

Even so, as with any data, a fund's numbers can mislead as well as educate. So it's important not to jump to conclusions too quickly. Below we offer examples of a few issues to keep in mind when perusing the wealth of mutual fund information that's available these days.

Sector Bets That Aren't
A look at a fund's sector weightings can provide clues about the strategy it is pursuing and how it might perform under different market conditions. But be careful of a few traps. For example, sector weights have less meaning with focused funds--those whose managers put all the fund's money into a relative handful of companies. With those funds, you can be tricked into thinking a fund has made a sector play or has changed its strategy when in reality it simply has made a decision on one or two companies.

A current example can be found at Longleaf Partners LLPFX. The fund's latest annual report shows it has 14% of assets in technology--a somewhat surprising amount for managers known for their strict adherence to a value philosophy. That's roughly equal to the S&P 500's stake. Does this mean the Longleaf managers have turned bullish on the tech sector? Should you think you're getting a "market weighting" of technology if you own Longleaf Partners?

Well, the number is accurate, and it does show that these managers don't cut themselves off from a sector just because it isn't traditionally considered value territory. Just as important, though, is the fact that the fund's tech stake consists entirely of two companies: Dell DELL and Philips Electronics PHG. The managers have 9.4% of assets in the former and 4.7% in the latter. So, it doesn't seem like a broad statement about the attractiveness of an entire sector--especially if you're familiar with Longleaf's investment philosophy, which eschews sector-based investing. And while it's true you're getting a market weighting in tech if you own this fund, that information is of dubious value. Individual stocks--particularly ones as fraught with company-specific issues as Dell--won't necessarily perform in line with the tech sector as a whole.

How Assumptions Can Fall Short
Even if a fund's sector weighting consists of many different stocks and thus seems more likely to move along with the overall sector, there could be more to the story. Some managers point out that the broad financials sector, in particular, actually consists of various subsectors that can respond very differently to external factors. If some of the holdings making up a fund's financials weighting are insurance companies, and others are brokerages, and others are regional banks, and others are mortgage brokers, the managers have a point. On the other hand, if a fund with a large financials stake has most of it concentrated in one subsector, that's worth knowing, too.

Also keep in mind the sizes of the sectors in the marketplace. The financials sector makes up about 22% of the S&P 500. So, an 18% weighting, which might seem hefty considering it might be bigger than any others in a fund's portfolio, is actually an underweighted stake for a large-blend fund.

You can also be led astray by country weightings. If you're wary of Japan's prospects, for example, you might avoid funds with an overweighted stake in that country. But would that be prudent? Japan was by far the worst-performing big market in 2006, and it's true that a fund with a big stake in that market almost certainly would have performed better had it stashed all that money in, say, Spain, which rallied strongly. But that doesn't mean such a fund was doomed. Take a look at Putnam International Capital Opportunities PNVAX: Although it had the fourth-largest Japan weighting of the 30 separate funds in the foreign small/mid-value category in 2006, that fund also had the fourth-best 2006 return. One reason was that its particular Japan picks beat Japan's overall market; another reason was the strong showing of the rest of its portfolio. Conversely, Tweedy, Browne Global Value TBGVX had the tiniest Japan stake of those 30 funds, yet it had one of the lowest returns. (In that case, being fully hedged into the dollar played a big role.) In short, while country weightings can provide some useful information--particularly where more-volatile emerging markets are involved--take care not to put too much emphasis on them.PAGEBREAK

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