Is Your Fund Betting on Overvalued Sectors?

Holding an outsized allocation to a given sector of the stock market can be a boon or a bane to a fund. If the sector outperforms, the fund very well may benefit by participating in more of that gain than its peers do. If the sector underperforms, the opposite may hold true. A fund that's overweight in a significantly overvalued sector carries added risk--namely, the risk that the fund could get hammered if there is a correction in that area of the market.

An overweighting in an overvalued sector doesn't necessarily portend doom for a fund. By picking the right stocks within the sector--meaning those that are not overvalued or that hold up better in a correction--a skilled manager may avoid, or at least mitigate, the negative impact of a sector downturn. For example, the Gold-rated
 Yacktman (YACKX) fund currently holds one third of its portfolio in the consumer defensive sector, which Morningstar's equity analysts say is somewhat overvalued. (By comparison, both the benchmark S&P 500 and the large-blend category average give about an 11% weighting to the sector.) That large a sector overweighting might set off alarm bells in the hands of an unproven manager, but father/son comanagers Don and Stephen Yacktman have a long and distinguished track record that suggests they have a pretty good idea of what they're doing.

Investors who want to check overweightings in the funds they own can click on the Portfolio tab on a fund's Quote page on Morningstar.com. There they can compare the fund's sector weightings with those of a benchmark and with the category average. Once they've identified overweight sectors, investors can look on the Market Fair Value page under the Sector tab to see whether Morningstar's equity analysts think the sector is priced fairly, too high, or too low based on their price/fair value ratios for all of the companies they cover in that sector. A long, high trail of red on the chart for a given sector could spell trouble. Keep in mind that market fair value data is updated daily, but fund portfolio data is updated only periodically, so actual fund allocations on the date you are checking may be different.

In addition to consumer defensive stocks, consumer cyclicals and industrials currently are among the most overvalued sectors, according to Morningstar's equity analysts. Investors who own or are considering buying funds that are overweight in these sectors and that have managers who lack a strong track record of winning sector bets and/or stock-picking might want to think twice, or at least take a closer look to see whether the fund's holdings are overvalued.  

To identify stock funds that are overweight in overvalued sectors, we set the
 Premium Fund Screener tool to search for diversified stock funds with allocations to the consumer defensive, consumer cyclical, or industrial sectors that are at least 10 percentage points above that of the  Vanguard Total Stock Market Index (VITSX), a proxy for the U.S. equity market. We only included funds rated Neutral or Negative by our fund analysts, meaning they are funds with managers who have not distinguished themselves or with other question marks. Also, we excluded institutional funds and applied the distinct portfolio screen to eliminate duplicate share classes.

It bears repeating that these funds aren't necessarily bad just because they are overweight in sectors that Morningstar's equity analysts believe are currently overvalued. But for investors who own them or who are considering buying them, an extra dose of due diligence is ideal.

Premium Members can see the full list  here. Below is a sampling of a few of the funds that passed the screen. 

 Columbia Marsico Focused Equity (NFEAX)
This large-growth fund's thematic approach typically leads to sector overweightings, and its managers' belief that the U.S. and global economies will continue to recover has led to a 32% weighting in consumer cyclical stocks such as  Home Depot (HD) (currently with a Morningstar Rating for stocks of 2 stars) and  Wynn Resorts (WYNN) (currently rated 4 stars), nearly double the category average. The fund's portfolio is rather concentrated at around 30 holdings. It is up about 18% so far this year, near the top of its category, but its five- and 10-year annualized records are both around the 40th percentile. Morningstar fund analyst Karin Anderson says the fund's high-conviction approach has led to prolonged rough patches. Recent turnover on Marsico's investment team is another concern.

 Gabelli Small Cap Growth AAA (GABSX)
When it comes to overweighting stocks in overvalued sectors, this fund is a triple threat. It has overweightings in consumer cyclical (27% of the portfolio), industrials (22%), and consumer defensive stocks (11%), all of which are above the small-blend category average. Manager Mario Gabelli likes cash-generating firms trading at a discount to their estimated intrinsic values, and he has a strong track record with three-, five-, and 10-year annualized returns that land in or near the top quintile of the fund's peer group. But Morningstar analyst Flynn Murphy points out that the fund's 1.41% expense ratio is on the high side for a no-load, small-cap fund and that Gabelli manages 15 other funds along with serving as chairman and CEO of the parent company, leading to concerns that he might be spread too thin.

 Baron Asset Retail (BARAX)
This mid-growth fund's low-turnover, high-quality portfolio currently includes a 27% stake in industrial stocks, such as  Verisk Analytics (VRSK) (rated 2 stars) and
 Fastenal (FAST) (rated 3 stars), and a more modest overweighting in consumer cyclical stocks (24%), such as  Ralph Lauren (RL) (rated 2 stars) and  Discovery Communications (DISCA) (rated 2 stars). Fund manager Andrew Peck likes companies with sustainable competitive advantages and predictable growth. The fund has been a consistent, if unspectacular, performer, with three- and five-year annualized returns at or close to the mid-growth category average. The 1.33% the fund charges in annual fees is higher-than-average for a no-load, mid-cap fund.

Portfolio data for all funds as of March 31 except for Columbia Marisco Focused Equity, which is as of April 30; all performance data as of June 3.