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November's Mutual Fund Red Flags

Tread carefully with these four superconcentrated funds.

Gregg Wolper, 11/14/2006

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.

A key reason to own mutual funds or exchange-traded funds, instead of just picking up a few individual stocks or bonds, is diversification. With a fund that spreads its assets around widely, the detrimental impact of one or two blowups is muted.

Some funds, however, don't consider diversification a primary goal. Or they simply can't be very diversified because their mission makes it impossible. Of course, a concentrated portfolio isn't in itself a reason to avoid a fund: Certain talented managers have thrived by focusing on the picks in which they have most conviction. But as you add a concentrated fund to a client's portfolio, be sure to take the fund's concentration into account and adjust the weighting in the portfolio to a level where you'd be comfortable when the inevitable steep sell-off comes. For example, the first two funds below are so volatile, you'd want to keep them to less than 5%, while the latter two should be held to 10% or less for most investors.

Vanguard Telecom Services ETF VOX
Exchange-traded funds have gained lots of attention (and assets) over the past few years. Yet many of them have a high concentration of assets in their top holdings. This fund is a prime example. At the end of September, it had an astounding 33% of assets in its top two stocks--19% in AT&T T and 14% in Verizon Communications VZ. As if that weren't enough, the rest of the top picks also have high weightings. As a result, fully two thirds of this fund's assets are in its top 10 holdings.
 
IShares S&P Latin America 40 Index ILF
All Latin America funds run into a roadblock on the way to diversification: Only two markets in the region--Brazil and Mexico--have any real size and breadth, and throughout the area there simply aren't all that many topnotch, actively traded stocks to choose from. The region did have a few more globally competitive companies a few years ago, but some of the most attractive were snapped up by acquisitive European pursuers. As a result, this fund has nearly 90% of its assets invested in Brazil and Mexico, and more than 60% of its assets reside in its top 10 names.

FBR Small Cap FBRVX
We like this closed fund's manager and think current shareholders should feel comfortable sticking with it. However, in case it opens up again--or if you're an owner who hasn't been paying much attention--be aware: This fund is really, really concentrated. In its most recent portfolio, it had more than 33% of assets split almost evenly between just two stocks, American Tower AMT and Penn National Gaming PENN. Altogether, it has more than 70% of assets in its top 10. This level of extreme concentration is more than the norm for manager Chuck Akre, but only by a matter of degree. Yet he's made this unusual strategy work. For the trailing five years, the fund has one of the best returns in the small-growth category, while having suffered much less volatility than the norm for that group.

Davis Financial RPFGX
Here's another fund run by topnotch managers in whom we have great confidence, and yet whose portfolio is so concentrated one must take that fully into account before buying in. Managers Chris Davis and Ken Feinberg have run up excellent records at their more broadly diversified mutual funds, where they're not averse to putting significant assets in their favorite companies and in financials, broadly defined, in particular. As a sector fund, though, this one carries that concentration much further. It currently has more than 70% of assets in its top 10, with nearly 12% of assets in top holding American Express AXP.

Gregg Wolper is a senior analyst with Morningstar.

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