How Mutual Fund Portfolios Can Fool You

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  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.

Now You See It, Now You ... Don't Know
Some investors like to look at fund portfolios in order to get ideas for their own stock picks. Nothing wrong with that--if you own a group of stocks instead of, or as a complement to, mutual funds, then looking to see what topnotch investors are buying or selling is a sensible way to gain ideas or test your own conclusions. However, you have to be careful when using portfolios in this manner.

First, remember that even if a stock appears near the top of a fund's list of holdings, that doesn't mean the manager is buying it now. Many times I've spoken with fund managers who say that although they still like a certain company that is in their top 10 they recently sold some shares because price appreciation made it much more expensive than when they first bought it. In other words, if you simply see the company's name near the top of the portfolio and buy it, you might be jumping in at the exact moment the manager you respect has been selling--exactly the opposite of the process in which you think you're engaged.

A closer look at the fund's reports (or the portfolios on Morningstar.com, which use plus and minus signs to indicate if a position has grown or declined since the last portfolio) can help you in this regard. But even then, even a recent portfolio doesn't reflect what the manager is doing right now.

Second, even the best managers make mistakes. Just because a renowned manager is buying XYZ Inc. doesn't mean you should put a sizable chunk of money into that company, too. No matter how talented, that manager has bought a clunker or two over the years--probably more. The manager has succeeded nonetheless because he's also owned plenty of other winners that have overshadowed the losers; if you don't own those as well (and you almost surely don't), you're out of luck.

That's why, if you're using portfolios to get stock ideas, it helps to consult not just one but a broad array of stellar managers. It's possible they'll all be wrong on the same stock, but it is less likely than just one of them being off. In addition, it's always advisable to do your own analysis on the stocks as well--and to keep your individual stock positions to a reasonable size, whatever that might be in your case.