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Could These Funds Be Too Hot to Handle?

Performance has been phenomenal, but these medalists could mean-revert in a 'risk-off' market.

Notwithstanding my recent fair-weather fandom of the Chicago Blackhawks, I tend to be innately disdainful of anything that smacks of trend-chasing. That extends to my investing habits, too. If I'm scouting for something to add to in my portfolio and I'm confident I've done my homework on it, I'd rather buy it when its performance has looked lousy than when it's at the top of the charts and other investors are flocking to it. On the flip side, if something I own has performed particularly well, I'm inclined to pare it back, or at least limit new purchases.

A contrarian investing style also has its roots in fundamentals: If an investment hasn't performed especially well, that can be a signal that it's attractively priced, while hot performers frequently revert to the mean. Morningstar's equity-analysis methodology places a big emphasis on valuation, of course. But our fund analyst rating system is less keyed in on valuation. Analyst reports frequently take note of the risks of a fund that's heavily tilted toward highly appreciated sectors or stocks, but those risks won't necessarily prompt a downgrade. In part, that's because our analysts expect that fund investors will have a holding period that's long enough to help offset a bum entry point. Morningstar analysts' reticence to make valuation calls on funds also owes to the limitations of fund data: We receive fund portfolios on a monthly basis, at best, so we have a hard time knowing whether a fund manager is holding securities that could be overvalued or has given them the heave-ho.

That shouldn't stop investors from weaving a contrarian-minded, valuation-conscious approach into their fund-buying and -selling decisions, however. One quick-and-dirty way to do so is to pay attention to funds' trailing-return rankings relative to their category peers when deciding what to buy and sell. Otherwise-stellar funds with lousy returns during the past three or five years could be ready for a performance pop, while those with scary-good return rankings may be poised to come back down to earth. You wouldn't want to reflexively buy or sell based on those numbers, and positive or negative momentum can persist for a while. But when it comes to investing, past performance definitely doesn't predict future results.

In this vein, I frequently screen for Morningstar Medalist funds whose performance is in the dumps. This week, I decided to look for the opposite: medalist funds whose performance has been red hot, which I defined arbitrarily as being in the top 5% of their peer groups during the past three- and five-year periods. To focus on the funds with performance that bumps around quite a bit and, therefore, could be due for a weak patch, I screened for those with Morningstar Risk ratings of "High." I eliminated various allocation categories--a group that includes target-date offerings as well as various types of balanced and asset-allocation funds--because most of the funds that have shone over those periods are simply tilted more heavily toward stocks than their peers.

Seven funds made it through the screen, as of mid-August 2015. Of course, it's far from a cinch they'll all start choking tomorrow. But if you're contemplating additions to these funds right now, I think it's reasonable to temper your near-term expectations and perhaps consider dollar-cost averaging into a position rather than adding a lot of new money in one go. That's especially true given that the current rally has been looking a bit long in the tooth recently.

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to view the complete list of funds that made the cut or tweak the screen to suit their own parameters. Here's a closer look at three of them.

This is one of the most idiosyncratic funds in the high-yield category. Whereas many junk-bond funds diversify across many credits to limit issuer-specific risk, manager Bruce Berkowitz concentrates the portfolio in an ultracompact group of distressed-debt names. He also has the latitude to venture across the capital structure: The portfolio includes a sizable stake in preferred stock, including a 12% combined stake in Fannie Mae and Freddie Mac preferreds. Owing to its unique makeup, the fund's performance doesn't often move in lockstep with the high-yield group, for better and for worse; its annual returns land near the top of the heap--as has been the case recently--or the bottom. To get a good result from owning the fund, investors must have patience and a long time horizon.

Like Fairholme Focused Income, this offering is an outlier within its category. By prospectus, the fund must invest 80% of assets in companies that appear in the Nasdaq Composite Index or the over-the-counter markets. That mandate gives the fund more of an emphasis on technology names than its peers, as well as a smaller-cap tilt. The fund recently staked half of its portfolio in the technology sector, more than twice the stake of its average large-growth peer. That very aggressive positioning--as well as strong stock-picking--has helped the fund shine during the past six-plus years of the current market rally, but investors should also expect the fund to underperform during market sell-offs. Under a previous manager but with the same general mandate, the fund lost 46% in 2008. During the last big stock sell-off in the second quarter of 2012, with current skipper Gavin Baker at the helm, it lost 9% versus a 6% drop for the typical large-growth fund.

The team running the show here, led by Dennis Lynch, took home Morningstar's Domestic-Stock Fund Manager of the Year honors in 2013 after it gained nearly 50%. Morningstar has long been a fan of the process of Lynch and company, which prizes firms with defensible business models as well as high margins and returns of capital. The portfolio tends to be quite concentrated, with just 38 holdings as of its most recently available portfolio; that, plus its high-octane, technology-stock-laden portfolio, has led to streaky but impressive long-term results and above-average volatility. Like Fidelity OTC Portfolio, it tends to shine in risk-on markets but struggles when investors are feeling defensive.

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