China in the bull shop

Sometimes you know exactly what you’re getting yourself — or your clients — into. Sometimes it’s not so evident. Even when advisers perform sound due diligence on investments to ensure they are appropriate for clients’ goals and risk tolerance, a critical piece of information may not bubble up to the surface.

Take, for instance, the Delaware Healthcare I fund (DLHIX) with a Morningstar Inc. category of U.S. OE (open-end) Health. What may not surprise you: The fund is majority invested in the health care sector, with top holdings such as Eli Lilly and Co. and Bristol-Myers Squibb Co. What may surprise you: It has a 10% equity exposure to China.

InvestmentNews’ Trevor Hunnicutt reported recently on mutual funds and ETFs with an unexpectedly large percentage of assets dedicated to the Asian giant. When all goes well, bets on elevated exposure to a single country’s companies can pay off. But at a time when China is sorting through a serious market plunge and potential contraction in its fast-growth economy, such exposure can slice into gains. On either end, good or bad, higher concentrations come with higher volatility.

Financial advisers look at individual stock concentrations in funds, just as they evaluate sector concentrations or regional ones. And in funds labeled “emerging markets,” which countries factor high in the portfolio is an obvious consideration. But for funds not necessarily tagged as such, exposure to particular countries doesn’t get the notice it deserves.

The Delaware Healthcare I fund’s summary prospectus from July does not mention China once, and its 30-plus-page full prospectus mentions it only once, in reference to the portfolio manager’s having received a medical education in China.

SECTOR FOCUS

The fund’s annual report from March 31 shows allocations by sector, such as biotech and medical products, as well as the top 10 holdings. Nowhere, in an admittedly quick study with multiple searches, does it explicate exposure by country or region.

All of this is not to pick on the Delaware Healthcare fund. In fact, Mr. Hunnicutt’s analysis of Morningstar data turned up many such examples. The Guggenheim Solar ETF (TAN) had … wait for it … 36% equity exposure to China. Morningstar slotted this fund in its U.S. ETF miscellaneous sector.

The fund’s summary prospectus doesn’t mention China, either. Its full prospectus from December combines four ETFs and, at 57 pages, is a little unwieldy. It does, however, clearly show its heavy China weighting on its overview webpage for the fund, under geographic rankings. The lesson for advisers when considering funds: Look, look and look some more.

PUERTO RICO

Another telling example: Franklin Double Tax-Free Income (FPRTX), with 41% exposure to Puerto Rico. To be fair, the firm does mention Puerto Rico 18 times in its 10-page summary prospectus from July, but not until Page 4.

Some muni bond funds — indeed many fixed-income funds overall — have sought to outperform the competition during years of low interest rates by taking on riskier debt, and high concentrations in countries paying the most have sometimes resulted. This is analogous — with all its attendant complications — to the once hot topic of “style drift,” when, for instance, a large-cap fund might increase its small-cap holdings because they’re performing better at the moment.

So while it may be evident that investments called All Russia All the Time Fund or Big Bets on Brazil ETF are inclined toward heavy wagers on a single country, advisers must continually look for such leanings in any category.

It’s not a one-time thing at the point of purchase, either. Funds aren’t static; they shouldn’t be. But the popularity of “go anywhere” and “unconstrained” strategies demand even greater confidence in the managers at the helm and continual review by advisers.