(PUB) Morningstar FundInvestor

January 2 014

Morningstar FundInvestor

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Don’t Be Fooled by These Funds’ Five-Year Returns Red Flags | David Kathman

risk and liquidity risk. This proved a toxic combination in 2008 , when liquidity dried up and mortgages got hammered as the housing market imploded. As with the Nuveen fund, leverage magnified the fund’s problems, leading to a 36% loss that was among the worst in the multisector bond category. The fund rebounded with a 58% gain in 2009 but again ranked near the bottom of the category in 2011 , highlighting the considerable risks. Despite its top-decile five-year returns, the fund has an Analyst Rating of Negative. John Hancock Classic Value PZFVX As its name implies, this fund employs a classic value strategy, trying to identify large-cap stocks that are historically cheap but have good prospects for recovery.Manager Richard Pzena and his team run a fairly concentrated portfolio in which sector weight- ings can differ quite a bit from the broader market. That strategy backfired in 2008 when the fund lost nearly half its value because of a big bet on financial stocks, including Lehman Brothers, Washington Mutual, Fannie Mae, and Freddie Mac. The fund re- bounded nicely from that debacle and has had a great year in 2013 , but the risks of its contrarian strategy contribute to a Neutral Analyst Rating. Legg Mason Opportunity LMOPX Bill Miller has had his ups and downs, but man are the downs dangerous. Miller made a big bet on finan- cials in 2008 , contributing to a gut-wrenching 65% loss that was followed by an 83% gain in 2009 when the market’s riskiest stocks rebounded. Since then, the fund has ranked at either the bottom or the top of the mid-cap value category each year. While its five- year returns currently look great, the fund’s long-term returns haven’t compensated for the huge swings, resulting in an Analyst Rating of Neutral. œ Contact David Kathman at david.kathman@morningstar.com

This year marked the fifth anniversary of the 2008 financial crisis and market meltdown. It’s nice to see that terrible time retreating further into the rear- view mirror, but this anniversary also means that the brutal losses of 2008 have been rolling off mutual funds’ five-year returns, replaced by gains from the past year’s bull market. That makes those losses less visible, which is good news for funds that got hammered in 2008 , but bad news for investors trying to evaluate funds and their long-term records. Quite a few funds took it on the chin in 2008 , landing in their categories’ bottom deciles, but have rebounded strongly to achieve top-decile five-year returns as of December. You should be most wary of those with a Negative or Neutral Morningstar Analyst Rating. Nuveen High Yield Municipal Bond NHMAX High-yield bond funds, including high-yield municipal- bond funds like this one, got hit especially hard by the credit crisis in 2008 . This fund’s aggressive strategy focuses on bonds with long durations and plenty of credit risk, features that boosted returns during the good times but took a major toll during the crisis. Big losses in these credit-sensitive holdings, made worse by leverage, caused shareholders to pull money out of the fund and forced manager John Miller to sell hold- ings, resulting in a devastating 40% loss in 2008 . The fund has since bounced back strongly with some of the high-yield muni category’s best five-year returns, but the risks from its aggressive approach have not gone away, resulting in an Analyst Rating of Neutral. Putnam Diversified Income PDINX This multisector bond fund has historically allocated its portfolio among high-yield bonds, mortgage- backed securities, and non-U.S. bonds, and it gener- ally has avoided interest-rate risk in favor of credit

What is Red Flags? Red Flags is designed to alert you to funds’ hidden risks. Such risks can take many forms, including asset bloat, the depar- ture of a solid manager, or a focus on an overhyped asset class. Not every fund featured in Red Flags is a sell, and in fact, some are good long-term hold- ings. But investors should be prepared for a potentially bum- pier ride in the near future.