Harbor Capital Advisors Engages New Subadviser for the Harbor International Fund
 
Questions & Answers

August 22, 2018

The Harbor Funds Board of Trustees appointed Marathon Asset Management LLP (Marathon-London) to serve as subadviser to the Harbor International Fund effective August 22, 2018. Marathon-London replaces Northern Cross, LLC, which served as subadviser to the Fund since 2009.

As the adviser to the Harbor International Fund, we have high conviction in the investment capabilities of Marathon-London and believe that the Harbor International Fund and its shareholders will be best served by Marathon-London going forward. We appreciate that shareholders may have a number of questions about this change, including why Marathon-London was selected and how Marathon-London's selection will affect their investment in the Fund. The information below provides answers to many of those questions. Please do not hesitate to contact one of our Shareholder Services Representatives at 800-422-1050, Monday through Friday, between 8 a.m. and 6 p.m. Eastern time if you would like additional information about this change.

Questions:
Why did we make a change in subadviser?
Why did we select Marathon-London as the new subadviser?
How will Marathon-London manage the Harbor International Fund utilizing its EAFE Strategy?
How does Marathon-London's EAFE strategy differ from its ACWI ex-US strategy utilized for the Harbor Diversified International All Cap Fund?
How will the Fund manage the portfolio transition to Marathon-London?
How will this subadviser change affect the Fund's expense ratio?
What will be the impact of this subadviser change on the Fund's distributions in 2018?
What if I have additional questions about the subadviser change and its impact on the Fund?

 

Why did we make a change in subadviser?

Harbor Capital Advisors strives to deliver the most compelling investment results over the long-term for Harbor Funds shareholders. We do this in part by engaging talented, experienced investment managers to serve as subadviser to each Harbor fund. We then carefully oversee and monitor our subadvisers, scrutinizing not only performance but critical factors such as strategy consistency, portfolio trends, and changes to the firm or investment team.

We take a long-term view when evaluating a subadviser, and note that short-term periods of underperformance, by themselves, do not raise particular alarm. However, whenever there is a sustained period of underperformance as there has been with the Harbor International Fund, we intensify our evaluation of the fund and subadviser to better understand the reasons for the underperformance.

To provide our subadvisers with sufficient flexibility to execute their strategies, we do not employ a rigid set of criteria for determining when a subadviser is retained or replaced. We carefully consider a wide range of information, both quantitative and qualitative. In the end, we draw upon Harbor Capital Advisors' 30 plus years of experience as a manager-of-managers to carefully weigh all of the information, data and factors that our research produces to make the most informed decision we can for the benefit of fund shareholders.

We recognize that a change in subadviser is a significant decision. We pride ourselves in establishing long-term relationships with our subadvisers for the benefit of fund shareholders. For Harbor funds that have been in existence for at least 5 years, our subadvisers have an average tenure of 16.4 years. However, if our deliberate research leads us to conclude that shareholders of a Harbor fund would be better served over the long-term by a new subadviser, it is our responsibility as a manager-of-managers and as a fiduciary to recommend a change to the Harbor Funds Board of Trustees.

In the case of the Harbor International Fund, we have been carefully evaluating the reasons for the Fund's underperformance. We have spent considerable time with Northern Cross as part of this evaluation. We have also carefully evaluated potential replacements to Northern Cross.

We have a high degree of respect for the investment professionals at Northern Cross and remain ever grateful for their dedication to the Fund over many years. However, after very careful research and evaluation, we believe the shareholders in the Fund will be best served in the future by engaging Marathon-London as subadviser. The Board of Trustees of Harbor Funds were supportive of our research and, based upon our recommendation, unanimously approved the appointment of Marathon-London as subadviser to the Fund effective August 22, 2018.

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Why did we select Marathon-London as the new subadviser?

We selected Marathon-London after conducting a comprehensive search for a potential replacement that we believed would offer shareholders in the Fund a more compelling investment outcome over the long-term.

While we were familiar with Marathon-London from its service as subadviser to the Harbor Diversified International All Cap Fund since 2015, we did not commence our search anticipating that Marathon-London would be our selection. Our focus was to develop a diverse list of candidates that we believed were among the most compelling international equity investors from around the world. We did not constrain our search in any way, such as by firm type, geography, investment approach, or whether we had worked with the investment manager in the past. As our search progressed, we continued to narrow our list of candidates through concentrated due diligence on each candidate. At each stage of our research, Marathon-London continued to stand out as one of the most compelling candidates.

When evaluating our final group, we placed great weight on whether the candidate's investment approach would continue to allow the Fund to serve as a broadly diversified core international equity holding within an investor's portfolio. We also focused on the candidate's ability to take on a fund of this size from a capacity perspective without deviating from an investment strategy that has supported the candidate's record of superior performance.

We have high conviction in Marathon-London and believe Marathon-London will serve the Fund and its shareholders well for many reasons, including:

  • The high level of investment skill and competitiveness of Marathon-London's portfolio managers and analysts
  • Marathon-London's track record of successfully investing in international equity markets for over 30 years
  • Marathon-London's fundamental research with a long-term investment horizon resulting in low portfolio turnover and significant differentiation from the benchmark index
  • An investment approach providing broadly diversified international equity exposure across styles (i.e., growth and value), market capitalizations and geographies
  • An independent, employee owned firm with a very strong investment led culture
  • The sophistication of Marathon-London's trading, operations and compliance staff with the capability to effectively take on a Fund of this size

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How will Marathon-London manage the Harbor International Fund utilizing its EAFE Strategy?

Marathon-London will utilize its flagship EAFE (Europe, Australasia and Far East) strategy for the Harbor International Fund. Marathon-London has been running this strategy since 1987 and EAFE represents the firm's largest strategy. The MSCI EAFE Index will continue to be the Fund's benchmark index.

At the heart of Marathon-London's investment philosophy is the "capital cycle" approach to investing. This is based on the idea that the prospect of high returns will attract excessive capital (and hence increased competition), and the prospect of low returns will excessively depress new capital investment (and hence discourage competition). The assessments of how management responds to the forces of the capital cycle through their capital allocation strategy, coupled with how they are incentivized, are both critical to investment outcomes.

Given the long-term nature of the capital cycle, Marathon-London's portfolio construction process results in strong views relative to the market and long holding periods, often seven years or more. Marathon-London evaluates the attractiveness of an individual security within this longer timeframe. This also allows Marathon-London's investment team to seek investment opportunities in less exploited areas of the marketplace. This investment philosophy guides Marathon-London's portfolio managers in seeking investment opportunities in both the growth and value style universes and across the market capitalization spectrum.

Marathon-London's process is primarily bottom-up and focused on industry capital cycle characteristics, along with in-depth research regarding the company management's motivation, incentivization and skill at responding to the forces of the cycle. Marathon-London maintains an aggregate portfolio that is broadly regionally neutral (i.e., Europe, Japan and Asia Pacific ex-Japan) relative to the benchmark index. Country exposures within a geographic region, as well as security selection decisions, are made by each individual portfolio manager.

Marathon-London's investment team is organized geographically:

Europe Japan Asia Pacific (excl Japan
Neil Ostrer (36 / 31) William Arah (35 / 30) Michael Godfrey, CFA (19 / 5)
Charles Carter (28 / 19) Simon Somerville (27 / 1) David Cull, CFA (11 / 4)
Nick Longhurst (23 / 14) Simon Todd, CFA (19 / 5) and
Michael Nickson, CFA (14 / 5)
 
William MacLeod (7 / 4)    

Key: Portfolio Manager (Years investing / Years with Marathon-London)

 

Each of the 10 portfolio managers are allocated their own distinct portion of assets to manage within the Fund's portfolio. Each portfolio manager selects stocks within their region independently from the other portfolio managers with the exception of Messrs. Todd and Nickson who jointly manage their allocation to Japan. This generally results in a broadly diversified portfolio of between 350 to 450 holdings across those geographical regions.

The prospectus supplement for the Harbor International Fund provides additional information on Marathon-London's EAFE strategy, including the historical performance record for Marathon-London's EAFE strategy relative to the MSCI EAFE Index on a gross (before fees) and net (assuming the Fund's fees were in place over the performance period) basis. The fund summary prospectus may be accessed here.

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How does Marathon-London's EAFE strategy differ from its ACWI ex-US strategy utilized for the Harbor Diversified International All Cap Fund?

Marathon-London utilizes its EAFE strategy for the Harbor International Fund and its separate ACWI ex-US (All Country World excluding the United States) strategy for the Harbor Diversified International All Cap Fund. Marathon-London utilizes the same investment philosophy and approach for both strategies. The primary difference between these two strategies comes from the amount of emerging markets exposure. Marathon-London's EAFE strategy focuses primarily on developed foreign markets, with limited emerging market exposure. Marathon-London's ACWI ex-US strategy will focus on both developed and emerging foreign markets. The difference in emerging markets exposure between the two strategies as of June 30, 2018 was approximately 14%, with Marathon-London's EAFE strategy holding 6% in emerging markets and Marathon-London's ACWI ex-US strategy holding 20% in emerging markets. This generally tracks the difference in emerging market weightings within the respective benchmark indices, with the MSCI EAFE Index having no emerging market exposure while the MSCI ACWI ex-US index having emerging market exposure in the 20% to 25% range more recently. The Harbor International Fund held 10% in emerging markets as of June 30, 2018.

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How will the Fund manage the portfolio transition to Marathon-London?

With any change in subadviser comes the need to reposition the Fund's portfolio to those investments selected by the new subadviser. Harbor Capital Advisors and the Board of Trustees of Harbor Funds worked with Marathon-London to develop a comprehensive plan to transition the Fund's portfolio. This plan takes into account the market dynamics and liquidity of the Fund's current holdings and of Marathon-London's desired holdings.

Significant emphasis has been placed on effecting the transition in a manner that mitigates to the extent feasible the market impact of any sales and purchases of securities. We expect the Fund will maintain a modestly higher level of cash in the early days of the transition to be well prepared to meet redemption requests. We also expect that the Fund may obtain additional exposure to international equities through investments in broad-based foreign equity index funds and/or futures contracts in the short-term while Marathon-London sells existing portfolio holdings and works to transition the portfolio in a thoughtful and deliberate manner. Marathon-London also expects to retain a portion of the Fund's current portfolio securities, although not likely in the same weightings, as Marathon-London views those holdings to be consistent with its investment approach.

With the appointment of Marathon-London now effective, the portfolio transition process has already begun. Given the size of the Fund's portfolio, we expect the transition will take place methodically over the course of the next several months. As the transition unfolds, we will be flexible and patient to seek to ensure that sales and purchases of individual company stocks are made prudently and at competitive pricing levels.

Please Note:  The information above was originally published on August 22, 2018.  We published an update on the Harbor International Fund on November 6th, which includes information about the transition progress, performance of the Fund during the transition, and the average cash levels held in the portfolio.

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How will this subadviser change affect the Fund's expense ratio?

We imposed a cap in November of 2017 to help ensure that the Fund's total expense ratio remained competitive while the Fund experienced a decline in assets due to elevated redemptions. The total expense ratio cap (excluding interest expense, if any) is set at 0.64% for the Retirement Class, 0.72% for the Institutional Class, 0.97% for the Administrative Class and 1.09% for the Investor Class. This cap will remain in effect through the transition of the Fund's portfolio until February 28, 2019.

Maintaining a competitive expense ratio for the Fund is an important component of our value proposition for shareholders. As we do for each Harbor fund, we will evaluate the competitiveness of the Fund's expense ratio in light of the competitive landscape and then current asset levels in the Fund to determine whether, and at what level, an expense cap would be maintained for the following year. While we expect that Marathon-London will complete the transition of the portfolio before the expiration of the Fund's current total expense ratio cap, we intend to ensure that the Fund's expense ratio continues to be competitive at what may be lower asset levels for the Fund following this subadviser change.

Accordingly, we expect to continue to cap the Fund's total expense ratio through at least 2020 at levels that may be modestly higher than the current cap but below the levels that the Fund was experiencing before the cap was instituted in 2017 when the Fund had a substantially larger asset base. For the fiscal year ended October 31, 2017, with the Fund ending that fiscal year at $32.3 billion in assets, the Fund's total net expense ratio was 0.73% for the Retirement Class, 0.80% for the Institutional Class, 1.05% for the Administrative Class and 1.17% for the Investor Class. We intend to maintain the Fund's total expense ratio at levels through at least 2020 that will be lower than those fiscal year 2017 figures.

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What will be the impact of this subadviser change on the Fund's distributions in 2018?

Please Note: The information below was originally published on August 22, 2018. We published our 2018 Estimated Year-End Distributions on October 31st, as well as an update on the Harbor International Fund on November 6th, 2018.

We anticipate that many of the Fund's existing portfolio securities will be sold over time as Marathon-London migrates the portfolio to its desired investments. Because the Fund has had long holding periods for many of its investments, combined with generally appreciating equity markets over the past several years, many of the Fund's current portfolio securities have appreciated significantly in value since they were purchased by the Fund. This means that the transition of the Fund's portfolio will most likely result in the realization of a substantial amount of gains that will need to be distributed to Fund shareholders by the end of this calendar year under the requirements of the Internal Revenue Code. 

As of August 20, 2018, the Fund had $20.8 billion in net assets. Of those assets, $4.5 billion represented net market appreciation in those portfolio securities (often referred to as "unrealized gains"). The Fund had already realized $4.5 billion in net gains largely due to portfolio security sales necessary to meet higher levels of redemptions. We anticipate that most of these unrealized gains will be realized as the transition occurs over the next several months. As a result, we expect the Fund will make a significantly larger capital gains distribution to shareholders later this year as compared with past years.

While the Fund does not employ a tax-managed strategy, we have considered all reasonable approaches to help limit the taxable distribution. We have been working with the Fund's tax advisors and with Marathon-London to seek to minimize to the extent feasible the amount of gains that will need to be distributed to shareholders.

Even with these efforts, we estimate that the Fund's 2018 distribution will likely be in the range of $23 to $27 per share. The share price of the Fund's Institutional share class as of August 20th was $64.94. We expect that the Fund's 2019 distribution will likely return to a more normal level as most of the unrealized gains in the Fund will likely be realized and distributed in 2018. Even without a subadviser change, because of the significant outflows from the Fund and our expectation that such outflows would continue, we estimate that the Fund's 2018 distribution would have been in the $11 to $13 per share range and would have been in that same range again in 2019.

At this point in the year, it is difficult to estimate with precision the actual amount of the distribution that will be paid by the Fund at the end of the year. The actual amount will depend upon a range of factors, including the overall performance of the foreign equity markets over the remainder of the Fund's fiscal year, which portfolio securities are sold and when, and the level of shareholder redemptions that occur before the distribution date.

We will provide updates to this distribution estimate on Harbor Funds' website at the end of October and again in early December. These estimates will likely be more reliable as they will be made closer to distribution date. The 2018 distribution will be paid on December 17, 2018 to shareholders of record as of December 14, 2018.

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What if I have additional questions about the subadviser change and its impact on the Fund?

If you have any questions about this change in subadviser, please do not hesitate to contact one of our Shareholder Services Representatives at 800-422-1050, Monday through Friday, between 8 a.m. to 6 p.m. Eastern time.

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The Harbor Funds lineup of actively managed, no-load mutual funds had combined net assets of approximately $65 billion as of June 30, 2018. Each Harbor fund is managed by an institutional investment firm selected by Harbor Capital Advisors, Inc. and approved by the Harbor Funds Board of Trustees based on the firm's experience in a specific asset class. Fees and expenses apply to an investment in Harbor Funds and are described in each fund's current prospectus.

There is no guarantee that the investment objective of the Fund will be achieved. Stocks fluctuate in price and the value of your investment in the Fund may go down. Investing in international markets poses special risks, including potentially greater price volatility due to social, political and economic factors, as well as currency exchange rate fluctuations. These risks are more severe for securities of issuers in emerging market regions. Stocks of small and mid cap companies also pose special risks, including possible illiquidity and greater price volatility than stocks of larger, more established companies. The subadviser's assessment of the capital cycle for a particular industry or company may be incorrect. Investing in companies at inopportune phases of the capital cycle can result in the Fund purchasing company stock at pricing levels that are higher than the market dynamics would support and therefore subject the Fund to greater risk that the stock price would decline rather than increase over time.