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Small Cap Growth Fund —
Difficult quarter for U.S. small cap stocks
3rd Quarter, 2015
"We focused on companies that have more controllable drivers to their profit growth. "
– Westfield Capital Management Company, L.P.

The third quarter of 2015 proved to be a challenging period for small cap U.S. companies. The Russell 2000® Growth Index, a measure of growth-oriented companies in the small cap segment of the U.S. market, returned -13.06% during the three months ended September 30, 2015. The Harbor Small Cap Growth Fund trailed the index, with a return of -14.18% during the quarter. Year-to-date, the Fund’s performance of -5.86% slightly trailed the benchmark’s return of -5.47%.
During this market sell-off, defensive sectors, led by Utilities and Consumer Staples, performed best during the quarter. Because of the Fund’s focus on higher growth companies, these sectors were underrepresented in the portfolio, which detracted from relative performance. Additionally, poor performance in Technology, Industrials, and Health Care, particularly biotech, were also detractors from performance. The Fund’s overweighting in Financials, specifically banks and insurance companies, was a positive contributor to relative performance.
The Fund’s top individual contributor to performance during the quarter was Energy company Tesoro. In yet another difficult quarter for the Energy sector, Tesoro was able to produce positive returns. The largest detractors from performance were a pair of pharmaceutical stocks, AMAG and Pacira. The Health Care sector was jolted during Q3 as a result of political discussions regarding potential increased regulation of drug prices, which resulted in a sharp decline in these stocks.
Portfolio Manager Will Muggia’s comments were made in an October 14, 2015 interview. Highlights adapted from the interview appear below. All comments relate to the quarter ended September 30, 2015, unless otherwise indicated. All references to year-to-date are for the period January 1, 2015 through September 30, 2015.

Interview Highlights

Increasing Merger and Acquisition Activity
I think in Technology, and particularly in biotech, there is going to be more M&A activity because the valuations came down very sharply and there was very little differentiation. So the very good companies went down as much as the bad ones. Basically, all the M&A targets are down 30-40% from their highs. I think there will be opportunity there, and we’ve acted on that. We do not buy any names hoping they get taken over; but if you buy good assets at good prices, that can happen.
Consumer Trends Creating Opportunities
We continue to focus on three areas in Consumer: housing strength, auto demand, and leisure. Strong existing home sales, improving affordability, and the recent uptick in household formation continue to support growth in home-related spending. We have positions in housing renovation, furniture, building products, etc. Regarding auto demand, average fleet age is still near an all-time high, which combined with record-level product recalls is driving healthy auto repair trends. We also expect U.S. auto demand to continue to be strong as the leading indicators for auto sales, employment, income and confidence, have trended higher all year. Lastly, fueled largely by aging population demographics, people like buying experiences over things. So we continue to have names in the travel and leisure space that are doing quite well.
Potential Drug Price Regulation
The Washington experts feel that the potential for government price control is virtually zero. However, the noise factor caused a lot of investors to reduce Health Care exposure across the board. What was most frustrating to us was the market’s lack of distinguishing between companies that have been egregious price takers on undifferentiated drugs versus those that have highly differentiated drugs of tremendous therapeutic value.
Impact of Energy Sector Earnings Reports
The Q3 earnings for the Energy sector will be telling. We believe reported earnings are going to be horrible for the quarter. We think a lot of it is already priced in to the stocks. It will be telling how the market reacts to the lower guidance and the earnings misses. We think 20 to 30 percent of Energy companies should go out of business. They’re not earning their cost of capital. Unfortunately, people keep giving them capital.

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

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.