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In a Harsh Climate, Funds Get Creative

Unwanted adventurism or canny flexibility?

Gregg Wolper, 08/28/2012

To avoid potential legal issues, the typical mutual fund prospectus is remarkably broad (or, some would say, annoyingly vague). After slogging through pages and pages of technical details, an investor might conclude that the fund can do anything it wants. For example, conventional stock funds that intend to fill their portfolios entirely with common equities usually allow themselves the freedom to use derivatives, own bonds, or raise large amounts of cash, even if the managers have no intention of doing anything of the kind.

In practice, though, the strategies of most funds are fairly well circumscribed. Most managers would prefer to focus on their areas of expertise, and most advisors and shareholders became less accepting of true go-anywhere mandates over the years. Since the financial crisis that began in 2007, though, it has become more common for managers to use the freedoms their prospectuses provide. Morningstar's director of fixed-income fund research, Eric Jacobson, noted this pattern among bond funds last year.

To a lesser extent, stock funds are taking advantage of this leeway as well. In July, senior analyst Laura Lallos outlined how some equity-fund managers are investing in other funds, both public and private, to gain exposure in areas outside their usual purview.

It's even easier to find managers who have become less absolutist in informal ways--for example, by searching for a few opportunities in sectors or regions that they generally consider unattractive, instead of simply writing off the whole lot. Hard data is tough to come by, because some of these actions don't have to be reported in ways that can be easily tracked. But the trends seem evident.

Some investors may consider such activity to be unwanted adventurism, while others might welcome it an open-minded approach that's in their own best interests. In any case, it would be wrong to make a blanket evaluation of the merits. Often, determining whether stretching the investment boundaries is a wise idea comes down to the specific move in question, and of course, to the success of the execution.

Outside the Norm 
Former Janus manager Laurent Saltiel moved to AllianceBernstein in 2010 and now heads up the international-growth team there. His young fund, AllianceBernstein International Focus 40 AIIAX, runs with a compact stock portfolio targeting foreign markets. It's not billed as a long/short fund. However, the prospectus allows Saltiel to sell stocks short (that is, bet that their prices will fall), and unlike the vast majority of his peers, he does so. He says he had experience shorting stocks in a Janus fund not available to retail investors, and during a prior stint at a hedge fund.

Saltiel also hedges some of the fund's currency exposure, a tactic that used to be uncommon for international funds. Until a few years ago, nearly all foreign-stock funds were fully exposed to foreign currencies in their portfolios. Their shareholders preferred it that way, and the fund companies figured their managers were better off focusing on company analysis rather than trying to forecast currency movements. But while fully hedged stock portfolios remain rare, partially hedged ones now show up far more often than they used to.

It was surprising, for example, that Harbor International HAINX initiated a currency hedge against the Swiss franc in 2011. According to the managers, they hadn't used currency hedging in almost 20 years but felt it appropriate at a time when the Swiss franc was soaring to historically high levels as worried global investors sought refuge from the euro and the U.S. dollar. At about the same time, Dodge & Cox International DODFX also initiated a hedge on the Swiss franc, only their second foray into currency moves.

Meanwhile, Longleaf Partners LLPFX, although primarily a U.S. equity fund, has not limited itself to stocks for a long time. But these days it has been even more common to find the fund owning additional types of securities. Its most recent portfolios have included convertible bonds, convertible preferreds, call options, and swap contracts, in addition to U.S. and foreign common stocks.

Not Just What They Say 
Also noteworthy is the tendency of many managers to say they dislike a certain sector or market overall, but then to invest in selected securities from that area. This behavior could appear to reflect muddled or contradictory thinking, but it also can show that managers faced with very difficult conditions are demonstrating a refreshing level of flexibility rather than mindlessly following a self-imposed rule.

For example, Mark Yockey of Artisan International ARTIX recently told Morningstar how difficult it is to find well-managed companies in Japan that put shareholder interests near the top of their concerns. Unlike some fund managers, who report that they've seen steady improvement in the shareholder-friendliness of Japanese companies, Yockey says he thinks little has changed in 20 years. But does his fund steer entirely clear of Japan? No. Yockey has found a handful of companies, including top-10 holdings Japan Tobacco and Honda Motor HMC, whose fundamentals appeal to him, at prices he considers bargains. As a result, the fund's 13% stake in Japan isn't too far below the foreign large-blend average.

Similarly, the managers of Harbor International consider emerging-markets companies unappealing on the whole. They told Morningstar recently that the relatively few companies in emerging markets that meet their standards tend to sell at very high prices. That said, they do own a couple of Brazilian banks, Taiwan Semiconductor Manufacturing TSM, and a few other emerging-markets firms. The fund's overall emerging-markets stake is around the foreign large-blend norm of 11% of assets.

Free to Roam? 
Some shareholders might be angry or disappointed to find their equity funds venturing beyond conventional stock-picking or owning stakes in areas the funds' managers generally are wary of. No question, it's wise to be skeptical of anyone hyping a new fad or recycling an old one, claiming "this time is different." But conditions do change, and managers who try to adapt while maintaining their core philosophy may be serving shareholders well. Look at Warren Buffett. For years he did not invest outside the United States or take positions in commodities. Then, when conditions changed and attractive opportunities presented themselves, he did.

That doesn't mean all such ventures are to be applauded. Shareholders who suspect that their managers are veering outside their areas of expertise or altering time-tested strategies have a right to ask questions. For example, if a foreign fund that has never bought U.S. stocks suddenly shows up with a sizable stake in Apple AAPL, one might wonder if that's a thoughtful broadening of its core philosophy or merely an attempt to juice short-term returns by jumping on a hot name. But in a complex and challenging investing environment, it makes sense to allow some leeway for experienced managers who have earned the benefit of the doubt.

Gregg Wolper is an editorial director and senior mutual-fund analyst at Morningstar.
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