Closet index funds, foreign funds with big U.S. stakes and other surprises may be hiding in your portfolio. By Anne Kates Smith, Executive Editor August 5, 2011 Have you ever ordered a dish from Column A only to open the carton and find a selection from Column B? Or discovered a truth about your significant other that made you wonder about the person you thought you knew? It can happen that way with mutual funds, too. Sometimes, surprises lurk within -- holdings that cause a double-take, or a strategy you were not aware of (and may not endorse). The red flags below could simply alert you to details that a well-informed investor should know -- or signal that a wholesale reevaluation is in order. SEE ALSO: Kiplinger's Guide to Mutual Funds Closet Index Funds When you pay a pro to pick stocks, you expect something more than an index fund. If instead you get an index clone or near-clone, you lose on two counts. First, you sacrifice the possibility of index-beating returns. Second, you increase the risk that you'll actually lag the index because you're paying higher fees than you'd pay for a cut-rate index fund. A few years ago, Yale researchers developed a way to determine the degree to which a fund’s portfolio deviates from its benchmark index, a measurement they called Active Share. Today, a whopping one-third of all mutual fund assets are invested in closet index funds, says Antti Petajisto, one of the researchers, who's now a finance professor at New York University. Advertisement A fund’s Active Share isn’t something individuals can calculate easily. But you can find out what percentage of a fund’s return is explained by movements in its benchmark by looking up the fund’s R-squared value (punch in the symbol at http://finance.yahoo.com, then click on “Risk”). An R-squared value in the high 90s could indicate closet indexing, and it should give you pause if you also find a lot of overlap in the top holdings of the fund and its benchmark index. The fund’s prospectus will tell you if the index-hugging strategy is deliberate. You’ll find the bulk of closet indexers among large-company funds. With Active Share data from fund tracker Morningstar, we found plenty of suspects with high R-squared values, overlapping holdings and expense ratios above the 0.17% of assets that Vanguard charges for its Index 500 fund (symbol VFINX). The higher the expenses, the more lackluster the returns. Vanguard Windsor II Investor (VWNFX) and Fidelity Mega Cap Stock (FGRTX) each display some index-cloning characteristics. But thanks to below-average expenses, returns within a hair of their benchmarks are enough to put them in the top half of similar funds for the past three, five and ten years (unless otherwise noted, all returns are through June 30). But First Investors Blue Chip A (FIBCX) charges 1.46% and has trailed Standard & Poor’s 500-stock index by an average of 1.2 percentage points per year over the past three years. Prudential Large Cap Core Equity A (PTMAX) charges 1.48% and trailed the S&P by an average of 2.4 points annually over three years. Sector Fund Wannabes At the other end of the spectrum from closet indexers are funds whose managers place big bets on a particular investment theme or sector. At the moment, the poster child for this sort of backdoor sector investing is Fairholme Fund (FAIRX). Manager Bruce Berkowitz is taking a lot of heat for putting more than half of his fund’s assets in financial stocks. That compares with a 15% weighting in the S&P 500 and 19%, on average, in similar funds. Berkowitz admits to moving in too soon, but he is sticking by his banks. “Some people think we’ve slipped,” he said in a recent conference call with shareholders, “but we are smack-dab in the middle of our circle of competence with financial services.” (Fairholme’s concentration in financials was one reason we removed the fund from the Kiplinger 25 this year; the fund lost 8.7% in 2011 through July 8.) Advertisement Other ostensibly diversified funds are making big sector bets, too. Primecap Odyssey Aggressive Growth (POAGX) had 40% of its assets in health care stocks at last word, compared with 12% in similar funds and in the Russell Midcap Growth index; FPA Capital (FPPTX) is taking a nearly 40% stake in energy, compared with just 10% in similar funds and 7% in the Russell Midcap Value index. Big sector bets can be the hallmark of super stock pickers, and every one of the above funds has a respectable long-term record. But investors should be aware of outsize sector bets, have the patience for them to play out, and be willing to overlook a wrong turn or two over time. Hedge Fund Aspirations A parade of exotic new mutual funds practice the swashbuckling strategies of hedge funds -- selling short to bet on falling prices, investing in commodities, using derivatives and the like. But many investors might not be aware that their target-date fund -- that no-nonsense mainstay for retirement savings -- is also taking a walk on the wild side. Since many target-date funds got clobbered in 2008, their managers have been turning increasingly to so-called alternative investments in an effort to hedge against market risk and smooth out long-term returns. The rationale is sound but not without risk. “Investors look at target-date funds as vanilla packages of complete solutions where they don’t have to worry about the risks taken,” says Veerendra Virkar, an analyst at Financial Research Corp. “Now they’re getting exposure to commodities, derivatives, real estate investment trusts and, hence, increased risk -- but they’re not aware of it.” Advertisement For example, the Putnam Retirement Ready funds include, to varying degrees, positions in Putnam’s Absolute Return funds -- a collection of super-flexible funds that may invest in anything from commodities to emerging-markets bonds to mortgage-backed securities, and use short positions and derivatives to hedge risks or increase returns. Fidelity Freedom 2050 (FFFHX) has 10% of its assets in Fidelity’s Series Commodity Strategy (FCSSX), which invests in notes, futures contracts and swaps linked to 19 different commodities. Far-Flung Holdings Do you know where your fund is? It might be more of a globe-trotter than you realize. Consider Janus Overseas (JDIAX). Although its prospectus says the fund may have “significant” exposure to emerging markets, its 31% stake in those exotic lands might be a bit unnerving. But would investors seeking overseas exposure find the fund’s 18% stake in U.S. stocks even more disconcerting? Among the fund’s eight biggest holdings at last report: Bank of America, Ford Motor and Delta Air Lines. U.S. funds have a wandering eye, too. Oppenheimer Equity Investor A (OAAIX) has 48% of its assets in foreign stocks, Janus Contrarian A (JCNAX) has 36% invested overseas, and Hartford Capital Appreciation (ITHAX) has 35%. By comparison, the S&P 500 has zero. Many funds have succumbed in a big way to the promise of growth in China. Recent accounting scandals and trading halts in the U.S. involving Chinese companies prove that risks are also abundant. Among mostly domestic funds with a big footprint in China are Rochdale Mid/Small Growth (RIMQX) and Mid/Small Value (RIMKX). Each has more than 15% of assets in Chinese stocks.