Mutual Funds: 3 Biggest Losers of Q3

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Identifying the worst funds of the quarter can be just as meaningful as identifying the best funds.

mutual funds q3A three-month period of time can provide insights into style, sector and asset rotation, which may then provide clues about where the broad market and economy may be headed in the fourth quarter of 2014 and into 2015.

Could the losers of the third quarter be value plays now? Or will the poor performance continue? Are there any signals that might indicate a broader market sell-off later this year?

To help answer these questions we’ll get a big-picture view of current and near-term economic and market conditions by looking at a variety of poorly performing mutual funds from different categories, including U.S. equity funds, sector funds and bond funds.

Worst Mutual Funds in Q3: US Equity

Pacific Advisors Small Cap Value Fund Class C (PGSCX): -11.4%PacificAdvisorsPromo

Our first clue about the near-term future direction of equity prices is the downward pressure on small-cap stocks in Q3. Our biggest loser, Pacific Advisors Small Cap Value Fund Class C (PGSCX) is not an outlier. Several of the worst U.S. equity funds were small-cap funds. The Pacific Advisors fund suffers more than its small-cap peers primarily because of a high expense ratio of 3.08%.

As of September 29, the average small blend fund returned -5.2% for the quarter, compared to 1.4% for the S&P 500 Index. This small-cap underperformance is a significant theme in 2014.

What I said last quarter applied then, and I believe it still applies: “Expect this underperformance to continue as the investor crowd grows increasingly doubtful of the bull market’s strength and continues shifting out of riskier stocks with smaller market caps than the S&P 500′s holdings.”

Worst Mutual Funds in Q3: Sectors

AQR FundsAQR Risk-Balanced Commodity Strategies Fund Class N (ARCNX): -18.0%

Commodities are not exactly an industrial sector, but they are an asset class that happens to be a specialized category of mutual funds that can provide insight into our study of worst funds here (I figured the word “sectors” would fit more neatly into the headline).

The biggest losers of any asset class or sector were primarily from the commodities category of mutual funds and AQR Risk-Balanced Commodities Strategies Fund Class N (ARCNX) was at the bottom of the pile. Top commodity holdings in the fund include copper and aluminum. For reference, both of these exchange-traded notes’ prices fell in the past month: iPath Bloomberg Copper Subindex Total Return ETN (JJC) fell -3.9% and iPath Dow Jones-UBS Aluminum Subindex Total Return ETN (JJU) fell -8.2%.

The quick and severe decline is likely due to commodities investors getting nervous about the end of quantitative easing and the rise of interest rates, which became more evident and more clearly communicated by Janet Yellen and the Fed during the third quarter… and commodities prices reacted negatively.

Commodities funds are commonly used as diversification tools in portfolios because the asset class has such a low correlation to the stock market in general. What the weakness in Q3 2014 says about the economy and stock market going forward is not clear, but this is not an asset class or fund type for beginners, to say the least.

Worst Mutual Funds in Q3: Bonds

lord-abbett-185Lord Abbett Emerging Markets Lcl Bd C (LEMCX): -6.2%

Another trend from the second quarter extends into the third quarter — big declines in emerging markets bond funds. Investors continue to flee riskier assets and security types.

Lord Abbett Emerging Markets Lcl Bd C (LEMCX) got hit in Q3 because of its over-sized exposure to low credit quality foreign debt, with nearly 80% of holdings at investment grade or lower ratings. It’s expense ratio of 1.77% drags on performance and makes fund management’s difficult to keep up with comparable index funds or exchange-traded funds, such as iShares Emerging Markets High Yield Bond ETF (EMHY), which had a -3.0% return for past the three months.

In summary, investors appear to be in a “risk off” mode as in the second quarter of the year. If this trend continues, which is difficult to imagine that it won’t, it is still wise to avoid areas perceived to be risky in the face of stock price volatility and rising interest rates, such as our losers in small-cap stocks, commodities and emerging markets bonds.

As of this writing, Kent Thune did not hold a position in any of the aforementioned securities. Under no circumstances does this information represent a recommendation to buy or sell securities.

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