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Small Cap Growth Fund —
Stocks continued to recover from Brexit-related volatility
3rd Quarter, 2016
"The quarter was mostly encouraging from a macroeconomic standpoint. "
– Westfield Capital Management Company, L.P.

Financial markets recovered from the Brexit-induced sell-off by early July and, as evidenced by high yield spreads declining during the third quarter of 2016, they continued to heal from their earlier volatility. During the quarter, small cap stocks outperformed large and mid cap stocks, and growth stocks outperformed value stocks. In the U.S. small cap growth equity market, as measured by the Russell 2000® Growth Index, the Energy sector performed particularly well, although it represented a small portion of the index. The Information Technology and Health Care sectors also performed well. Conversely, the Telecommunication Services and Utilities sectors, small weightings in the index, declined.
For the third quarter of 2016, the Russell 2000® Growth Index, a measure of growth-oriented companies in the small cap segment of the U.S. market, returned 9.22%. The Harbor Small Cap Growth Fund underperformed its benchmark, with a return of 8.34%. Stock selection and an underweight position in the Energy sector detracted from relative performance for the quarter. Conversely, an underweight allocation and stock selection in the Real Estate sector contributed to relative results.
Westfield Capital Management Company’s comments were made in an October, 2016 report. Highlights adapted from the report appear below. All comments relate to the quarter ended September 30, 2016, unless otherwise indicated. All references to the year-to-date are for the period January 1 through September 30, 2016.

Interview Highlights


A Mostly Encouraging Macroeconomic Backdrop
The quarter was mostly encouraging from a macroeconomic perspective. The 10-year U.S. Treasury yield rose modestly, and the price of oil was stable. Consumer confidence hit a five-year high, and jobless claims fell to a post-financial-crisis low. Positive U.S. employment reports for June and July boosted investor expectations that the U.S. Federal Reserve will go ahead with monetary policy tightening actions. However, data on home sales and manufacturing trends continued to point to tepid growth in the domestic economy. We think that even when interest rate hikes eventually come, their pace will be more gradual than the previous rate-tightening cycle. This environment of stable, albeit slow, economic growth and low interest rates suited equity investors during the quarter.
A Noteworthy Expansion of Market Breadth
There was a noteworthy expansion of market breadth during the quarter, with growth-oriented information technology, transportation, and biotechnology companies delivering some of the best performance results. Importantly, shares of financial companies joined the rally as the quarter progressed, a positive change from earlier in the year, when fears of a global economic recession put heavy pressure on such companies. However, as the second quarter reporting season highlighted, corporate earnings growth remained lackluster, and the market’s gains in the third quarter were mostly driven by improving investor sentiment and multiple expansion. We think that after the third quarter’s period of calm and complacency, volatility may pick up in the near-term.
The Federal Reserve May Start Raising Interest Rates
With emerging markets healing, the U.S. economy close to full employment, and inflation slowly firming, we believe the Federal Reserve is likely to start raising rates before year end, which could limit the appeal of low volatility, dividend-paying stocks. These stocks have led the market’s advance for the past few years and are very expensive, in our view. As such, they are underrepresented in the Fund. Their broad appeal appears to be fading, and we do not think they will be defensive in a market pullback.
We Favored the Industrials Sector
The Industrials sector was our third largest active weight entering the quarter, and we added three new investments during the quarter. As of the end of the quarter, Industrials was the portfolio’s largest sector overweight. Within Industrials, we have limited exposure to domestically oriented companies reliant on the pace of global growth and tried to focus on companies experiencing industry fundamentals. Specifically, we continued to favor shares of domestic transportation companies and airlines, and we remained positive on residential construction stocks.
Earnings Growth Needed to Support Equity Market Performance
The U.S. stock market finished September, its seasonally weakest month, on an upbeat note. While a further advance is possible, we believe the market will need to be supported by tangible earnings growth. We believe stock valuations are full, which in combination with uncertainty about the outcome of the U.S. presidential election and the timing of interest rate hikes, makes the possibility of a market pullback quite likely. We do not think the bond proxies will display defensive characteristics in a pullback.

Performance data shown represents past performance, which is no guarantee of future results. Current performance may be higher or lower than the past performance data shown. Investment returns and the value of an investment will fluctuate, and an investor's shares, when sold, may be worth more or less than their original cost. You can obtain performance data current to the most recent month-end (available within seven business days after the most recent month-end) by calling 800-422-1050 or visiting www.harborfunds.com.

Performance figures discussed reflect that of the institutional class shares.

The views expressed herein are those of the portfolio manager at the time of the interview and may not be reflective of their current opinions or future actions.  These views are not necessarily those of the fund company and should not be construed as such.

This information should not be considered as a recommendation to purchase or sell a particular security and the holdings or sectors mentioned may change at any time and may not represent current or future investments.