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Fund Spy

Beware Easy Explanations for Mutual Fund Performance

Look beneath the surface to learn why a fund is lagging--or leading.

A few months ago, I discussed various ways that a quick glance at mutual fund portfolios can fool you. For example, a large sector weighting could mislead one into thinking that a fund manager had made a play on a whole area of the market, when in fact the "sector exposure" consisted of a decisive investment in a couple of companies the manager happened to feel strongly about. Country weightings can mislead in similar ways. And it's also important to take care when trying to use fund portfolios as guides for your own stock-picking efforts--for instance, just because a stock shows up at the top of the portfolio doesn't mean the manager loves it right now.

In this follow-up, I'll look at some other ways that reaching judgments based on a too-quick look at a portfolio can prove misleading. By being aware of these pitfalls you can avoid making investment decisions based on faulty assumptions.

As Company Y Goes, So Goes the Portfolio?
Although we like the idea of giving talented managers the freedom to invest heavily in companies they feel most convinced about, we also recognize that such a tactic carries with it a definite risk. Namely, problems with just one or two holdings can have an outsized effect on the fund's performance--unlike the situation at most mutual funds.

That's common sense, but it also reflects the comments managers have made to us over the years. Often, when we ask why a fund's return has lagged in a certain period, a manager--with welcome candor--will concede that a top holding--which might take up "just" 3% or so of the fund's assets in some cases--ran into some problems the manager didn't foresee, and the resulting stock-price decline hit the fund's returns hard.

However, it would be wrong to assume that a big position at the top of the portfolio always drives returns. Some real-life current examples show why.  Oak Value , a small fund managed by admirers of Warren Buffett's methods, has a lot of money socked away in Buffet's Berkshire Hathaway. As of June 30, 2007, that position (including both A and B shares) made up 9.3% of Oak Value's portfolio. Buffett's expertise notwithstanding, though, Berkshire Hathaway's stock has done little this year: For the year to date through July 20, it was practically flat--plus 0.2% for the A shares and minus 0.6% for the B shares. The S&P 500 had gained 9.2% over the same period and the large-blend category average was a 9.6% gain. Therefore, one might expect Oak Value would be lagging both, dragged down by that immense Berkshire position.

In fact, the opposite is true. With an 11.5% year-to-date return, the fund is beating the S&P 500 by more than 2 percentage points and is in the top quartile of the large-blend category. The reason, as you might suspect, is that other positions have made up the slack--most notably, big gains by the numbers two and three holdings,  Apollo Group  and  Fidelity National Information Services (FIS).

What about  Oakmark Select (OAKLX), though? With nearly 14% of assets in  Washington Mutual (WM), a longtime favorite of manager Bill Nygren, it would seem that stock's 7% slide for the year to date would account for the fund landing in the large-blend category's bottom decile so far in 2007. Well, it sure hasn't helped. But look further:  Oakmark Fund (OAKMX), the similar but more diversified fund that Nygren also manages and which shares many of the same holdings, is having nearly as poor a year--and that fund has less than 3% of assets in Washington Mutual. The answer is that other Nygren favorites are also in negative territory so far this year.

The situation can work in reverse, as well.  Legg Mason Opportunity (LMOPX) has 7.7% in top holding U.S. Steel and 6.2% in number-two  NII Holdings , a telecom firm. The former is up 44.6% this year and the latter 38.9%. With such powerful gains in such huge positions at the top of the portfolio, it would seem impossible for the fund not to be topping the charts. But it isn't: Its 16% year-to-date return, while impressive on an absolute basis and much higher than the S&P 500, lands right around the middle of the mid-growth category. Quite a few of the fund's stocks further down in the portfolio have suffered double-digit losses so far this year, cutting into those big gains from the top two.

Can't Fight the Falling Dollar?
For a fund that invests in foreign stocks, a seemingly obvious influence on a portfolio's performance at a time when foreign currencies are soaring against the U.S. dollar would be the extent that a fund is exposed to those other currencies. After all, if the stock markets of Europe and Canada are rising, those currencies' gains are added gains for U.S. investors, as long as the fund hasn't hedged its currency exposure.

However, even though a hedged fund does face a hurdle beating the returns of rivals that are fully exposed to the rising euro, pound, Swiss franc, and Canadian dollar, that hurdle is not a brick wall. So far this year, of the three major stock funds that hedge most or all of their currency exposure, two are having banner years regardless.  Longleaf Partners International (LLINX) is beating 88% of its foreign large-value rivals, and  Mutual European (TEMIX) is trouncing 90% of the other funds in the Europe-stock group. Once again, the explanation comes down to the performance of specific companies in the portfolios.

Still, Don't Ignore the Obvious Explanations
All of the above is not meant to discourage you from taking a fund's focused nature or currency stance into consideration when making your investment choices. If one reason you are buying a foreign fund is to get exposure to other currencies for diversification purposes, you don't want a fund that hedges that exposure away. Indeed, although we've seen how that factor can be overcome, it did play a role in the weak relative performance in recent years for Longleaf Partners International (prior to 2007) and  Tweedy, Browne Global Value (TBGVX). Similarly, if you want a mutual fund specifically because you don't want to worry about the ups and downs of one or two stocks, buy one of the multitude of funds that spread its bets widely, with no stock getting more than 2% or 3% of assets, rather than one that puts large amounts into a few companies.

However, all others looking for a fund to buy--as well as anyone just trying to understand why certain funds have performed as they have--should keep in mind that what seems obvious on the surface often tells just part of the story.


Gregg Wolper has a position in the following securities mentioned above: OAKMX. Find out about Morningstar’s editorial policies.