(PUB) Investing 2015

April 2015

Morningstar FundInvestor

11

Biotech Fans Could Have a Hangover Red Flags | Alec Lucas

gain is in line with that index and over a percentage point better than the S & P 500 , though at the cost of greater volatility. Moving down the market-cap spectrum, mid-cap growth fund Eventide Gilead ETGLX at year- end 2014 held roughly 70 stocks, 22 of which were in biotech and pharma. They added up to 25% of the fund’s assets, 10 . 7 percentage points more than the Russell 2000 Growth Index’s. The fund’s over- weighting is typical, which makes sense given that comanager Finny Kuruvilla holds an M.D. from Harvard Medical School, as well as a doctorate in chemistry and chemical biology from Harvard Univer- sity, not to mention an engineering and computer sciences master’s degree from MIT . The fund’s sector biases and its timely July 2008 start date go a long way toward explaining how its 18 . 2% annualized gain through February 2015 manages to trounce the Russell 2000 Growth Index by 6 . 7 percentage points. That record comes with a bit of an asterisk, as the fund’s 25 . 6% loss in 2011 ’s third quarter was 3 . 3 percentage points worse than the index’s. For now, a repeat of that underperformance seems unlikely. The fund’s cash stake has surged to a since-incep- tion high of nearly 20% of assets, up from 0% at 2012 ’s close. and pharma, as of early 2015 . That’s 16 and 13 . 4 percentage points more than the MSCI All-Country World Index and category norm, respectively. Nearly half of the fund’s exposure is in top holding Nektar Therapeutics NKTR , a domestic small-cap firm. Big sector bets and a preference for smaller- cap firms is nothing new for longtime manager Frank Jennings. Still, the fund’s positon in Nektar is larger than usual, which is a concern. It suggests Jennings’ prior attempts to reduce the fund’s vola- tility, consistently among the category’s highest, have come to an end. That, along with succession risk, recently led to a downgrade in the fund’s Morningstar Analyst Rating to Neutral from Bronze. œ World-stock fund Oppenheimer Global Opportuni- ties OPGIX also has a 25% combined stake in biotech

Scientific breakthroughs can boost stock prices, but they can’t immunize them from sell-offs. That’s worth keeping in mind as biotech and pharmaceutical stocks, spurred on by the promise of innovations in genetic therapy, continue to boom. When markets go south, valuations matter, and with the all- cap Nasdaq Biotechnology Index (roughly split 80 / 20 between biotech and pharma) currently trading at a trailing 12 -month average price/earnings ratio near 30 versus the Russell 3000 Growth Index’s 22 , this corner of the market could be poised to fall further than others. The Nasdaq Biotechnology Index’s 18 . 2% plunge from early March to mid-April of 2014 was nearly 15 percentage points worse than the Russell index’s. As biotech has enjoyed a remarkable rally, we sought some funds with at least a fourth of their portfolios in biotech and pharma combined. Among Morningstar 500 funds without a health-care mandate, Fidelity Capital Appreciation FDCAX leads the way. In January 2015 , this fund, which carries a Morningstar Analyst Rating of Bronze, held a third of its assets—in a roughly 65 -stock port- folio—in biotech and pharmaceuticals. Investors familiar with manager Fergus Shiel’s go-any- where approach should not be surprised. With little regard for benchmarks or style drift, he focuses on companies with share prices poised to increase in the next six to 12 months. The short-term focus leads to high turnover but does not preclude doubling down on his bets, such as adding to the fund’s position in top holding Gilead Sciences GILD in December 2014 when concerns about a potentially cheaper alter- native to its revolutionary hepatitis C drug caused a share-price drop. Shiel’s willingness to dive in has in part led the fund to underperform the Russell 1000 Growth Index in cratering markets like the 2007 – 09 credit crisis. But from his late October 2005 start date through February 2015 , the fund’s 9 . 6% annualized

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 departure 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 holdings. But investors should be prepared for a potentially bumpier ride in the near future.

Contact Alec Lucas at alec.lucas@morningstar.com