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Small Cap Value Fund —
Strong advance for small cap value stocks
4th Quarter, 2016
"Our investment approach does not include investing based on predictions around political and macro events; rather, it is focused on finding businesses that we believe can outperform their industry peers throughout a full market cycle. "
– EARNEST Partners LLC

The U.S. equity market had positive returns in the fourth quarter of 2016. Market activity was heavily influenced by the outcome of the U.S. presidential election, which surprised investors. In the weeks following the election, stocks within the Financials and Energy sectors saw substantial appreciation.
The Harbor Small Cap Value Fund posted a return of 9.38% in the fourth quarter, but lagged the 14.07% return for its benchmark, the Russell 2000® Value Index. The Fund’s underweight to Financials, as well as stock selection in that sector, negatively impacted relative performance. In the Utilities sector, stock selection and an underweight drove a relative contribution.
EARNEST Partners’ comments were made in a January, 2017 report. Highlights adapted from the report appear below. All comments relate to the quarter ended December 31, 2016, unless otherwise indicated. All references to the year-to-date are for the period January 1 through December 31, 2016.

Interview Highlights


Economic Backdrop
At its meeting in December, the Fed unanimously voted to increase the short-term benchmark rate by 0.25%, to the range of 0.50% to 0.75%, the second rate increase since 2006. The committee stated that solid job gains, lower unemployment and increased household spending were key drivers of the rate decision, though they noted that inflation has remained below the committee’s 2% long-term goal while business fixed investments have remained soft. In the wake of the election, the U.S. 10-year Treasury rate, which began the quarter at 1.6%, surged higher and finished the year at 2.5%. Third-quarter GDP growth was revised up to 3.5% from the previous estimate of 3.2%, and the unemployment rate declined to 4.6% in November.
We Believe Regional Banks Are Overvalued
The small cap value index is unique compared to its core and growth counterparts in that regional banks make up 25% of the index. This pocket of the market witnessed dramatic price appreciation after the election. Regional banks, in aggregate, gained more than 30% from November 9th to the end of the year. The Fund has historically been underweight in regional banks as our process has led us to more attractive opportunities for long-term investment. However, during the quarter the relative underweight to regional banks had a significant negative effect on relative performance. From a valuation perspective, investors are now paying more than 20 times forward earnings for regional banks, whereas a year ago they were only willing to pay 15.7 times. When analyzing fundamentals, there is no indication it would be prudent to pay such a premium, as return on equity for that industry is lower than it was a year ago. Banks have not been growing loans as fast as they did in the previous 12 months, and net interest margins remain nearly identical to where they were a year ago.
Outlook
EARNEST Partners doesn’t maintain a formal outlook on the broader equity market. Rather, our investment decisions are made based on a company’s individual opportunities to grow earnings and take market share. Opportunities like these present themselves in all types of market environments, including today’s. Our view on what ultimately drives relative returns has not changed, and is inherent in our ability to identify and take advantage of mispricings in the market on an individual stock-by-stock basis.

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.