A Gold-Rated International Fund Gets Downgraded

The following is our latest Fund Analyst Report for Harbor International Fund HAINX. Morningstar Premium Members have access to full analyst reports such as this for more than 1,000 of the largest and best mutual funds. Not a Premium Member? Gain full access to our analyst reports and advanced tools immediately when you try Morningstar Premium free for 14 days.

Harbor International's opportunistic misfires, middling results, and rising expenses lead to a cut in its Morningstar Analyst Rating to Silver from Gold.

This fund's opportunistic bets have been problematic. In 2017, the fund’s thus far poor bet on Teva Pharmaceutical has hurt year-to-date results through September. Management built the position in the first quarter, and the stock was down 45% from quarter's end through September. As a generic drug manufacturer with little pricing power, Teva doesn't match the team's preference for strong franchises.

Although such opportunistic bets are on the margin, they have can have a significant impact on relative results. Beginning in 2012, an atypical bet on materials stocks contributed to three consecutive bottom-quartile calendar-year returns. Such bets are not new here either, as the fund made Russian energy company Lukoil its top-holding in the late 1990s. But the fund hasn't produced good results on this front during the past five years.

It has been seven years since lead manager Hakan Castegren died and more than eight years since the three current managers were named; this period arguably covers a full market cycle. The fund has beaten the MSCI ACWI ex-USA Index by about 50 basis points annualized since the three comanagers were named in 2009. But, owing to the fund’s greater volatility, it matches the index only on a risk-adjusted basis. The team deserves a share of the credit for the fund’s excellent results while Castegren was lead manager, but its performance since they became comanagers has been good, but not great.

Finally, as total assets have fallen because of outflows, the fund’s expense ratio has risen 6 basis points in the past three years. While the fund’s expenses remain below-average overall, rising expenses further chip away at the margin versus its foreign large-cap institutional rivals, with the peer median expense ratio falling by 5 basis points during that same stretch.

This fund still holds promise, but its edge looks a bit slimmer than in years past.

Process Pillar: Positive | Kevin McDevitt, CFA 10/27/2017 This fund ignores short-term volatility and focuses on the long term. These are investment cliches, but here they are competitive advantages and earn the fund a Positive Process rating.

Management looks for long-term catalysts that may not materialize for three to five years. The team searches for structural shifts that will affect industry pricing power and competitive advantages, which drive profits over the long run. The investment team monitors about 300-350 companies that it deems high-quality based on enduring competitive advantages and that have the potential for margin improvement. That said, the team will make short-term, opportunistic investments in lower-quality companies if the price is right. While such bets tend to be a small part of the portfolio, they can have a big impact on relative performance, and the team has made some missteps in this area in the past five years.

The long-term focus keeps trading to a minimum. The fund's annual turnover is usually below 20%, implying an average holding period of five years or more. While the team pays attention to valuation, it is a secondary consideration. As a result, the portfolio's average price multiples are often slightly above the foreign large-blend Morningstar Category average. Sell decisions are more often driven by changes in a company's competitive strength than by its valuation.

This fund has substantially reduced commodity exposure in recent years. Believing that demand from China and other emerging markets would drive prices, the fund built heavy positions in energy and materials in 2010. In recent years, the fund has reduced its energy weighting to just 4.2% of assets as of September 2017, below the MSCI ACWI ex USA Index's 6.6% weighting. The fund's materials stake has fallen to 1.7%, well below the index's 7.9% and far smaller than its 14.7% September 2012 stake.

The team has also reduced its stake in emerging markets to just 8.1% of assets versus 17.5% for the index. Recall that the fund's emerging-markets stake has at times been close to 20% and hit 15.7% in December 2009. That said, the fund holds a prominent position in Chinese Internet retailer Alibaba.

The team tends to focus on companies with long-term competitive advantages. It has long maintained an overweighting in consumer staples stocks such as Nestle and Diageo, which own strong global brands. It also has big overweightings in consumer discretionary stocks (especially casinos), as well as pharmaceutical and biotech companies. Since few telecom and utilities companies have competitive advantages of any kind, they rarely appear in the portfolio. There are also few tech companies, as the team believes competitive advantages in this sector are fleeting.

Performance Pillar: Positive | Kevin McDevitt, CFA 10/27/2017 This fund's long-term returns remain strong, earning it a Positive Performance rating. But it has been a volatile performer.

The volatility stems in part from management's occasional willingness to embrace emerging markets and, more recently, tolerating stocks trading at above-average price multiples. The fund's results during bear markets is mixed. Its calendar-year returns landed in or near the category's top quartile during the 2000-02 bear market. Although the fund took a beating during 2008's crash in absolute terms, it was no worse than average.

However, the sell-off in late 2011 was a reminder of how volatile the fund can be. It fell 22.8% during 2011's third quarter versus a 20.9% drop for its average peer--overweightings in emerging markets, materials, and financials hurt as global markets sold off. During the 2015-16 bear market, the fund’s 25.7% peak-to-trough (May 15, 2015-Feb. 11, 2016) drop lagged the index by 1.1 percentage points.

It has now been more than seven years since former lead manager Hakan Castegren died in October 2010. Since then, the fund edged its MSCI ACWI ex-USA Index through September 2017, gaining 5.55% annualized versus 5.17% for the benchmark; but it trailed the 5.66% category average. The fund has also outperformed since the three comanagers were named in February 2009. Since then, the fund gained 10.5% annualized versus the index’s 10%.

People Pillar: Positive | Kevin McDevitt, CFA 10/27/2017 This team has a solid trio of managers following two losses. Former lead manager Hakan Castegren died in October 2010. While Castegren's passing was certainly a loss, the fund was prepared for the transition. Although the remaining comanagers were listed on the fund only in February 2009, they had worked with Castegren for years prior to that. Comanager Jim LaTorre became the team's director of research in 1993. Howard Appleby and Jean-Francois Ducrest had both worked with Castegren for years as sell-side analysts before joining subadvisor Northern Cross in 2002. The team dealt with another departure when Ted Wendell stepped down in June 2014. But the team had been preparing for his retirement for years.

Since the team shares research duties, it is easy to shuffle assignments. The team's long-term orientation creates a culture conducive to deep thinking. The comanagers are all generalists, rather than dividing along industry or sector lines. The team's interests are well-aligned with fundholders', as all of the comanagers own stakes in the fund worth more than $1 million. The fund earns a Positive People rating.

Moreover, the team has added analysts. It hired Scott Babka from Morgan Stanley as an analyst in 2010, naming him research director in 2012. Hai Gao joined in 2012, although he left in early 2016. Adam Feldman joined the team in March 2014, with David Lerner following in early 2016.

Parent Pillar: Positive | 05/08/2017 Harbor Capital Advisors is known for hiring best-in-class subadvisors to run its funds. Harbor is a wholly owned subsidiary of Dutch asset manager Robeco Groep N.V., which has remained hands-off as a parent since first acquiring Harbor in 2001. Robeco was sold in mid-2013 to the Japanese financial-services firm ORIX, but Harbor has reported enjoying the same independence that it has had all along.

Harbor will continue to select and monitor managers on its own terms. (It has chosen not to use any Robeco managers, for instance.) A 10-person research team favors managers with a history of consistent risk-adjusted performance and repeatable strategies. Most of those managers invest alongside shareholders, with the majority holding more than $1 million in the strategies they run. Subadvisor changes have been rare, as evidenced by an average manager tenure of 8.2 years and a five-year manager-retention rate of 94%.

The firm's small target-date series is on the expensive side, but Harbor also offers access to topnotch managers at prices cheaper than are available elsewhere. For example, the institutional share class of the small Harbor Real Return fund has a 0.54% expense ratio. Yet PIMCO Real Return--the fund on which it is modeled--is roughly 110 times its size, and its comparable share class charges 0.85%.

Price Pillar: Positive | Kevin McDevitt, CFA 10/27/2017 The fund's Institutional share class, which holds about 85% of its assets, sports a below-average 0.79% expense ratio per the March 2017 prospectus. This places it in the below-average quintile of foreign large-cap institutional peers. The fund's expense ratio has risen as assets have shrunk. The fund has had nearly $19 billion in outflows in the past three years through September 2017. Overall assets have dropped by more than $20 billion in just more than three years, from $53.3 billion in June 2014 to $32.8 billion in September 2017. Likely as a result, the fund's expense ratio has risen 6 basis points since 2014. The fund's low turnover keeps trading costs in check. Its 2016 brokerage commissions were just 0.03% of assets.