Letter from the Chairman
Dear Fellow Shareholder:
Over the past year we have experienced bouts of both real optimism and real disappointment. As summer began, there was a sense that we had finally turned the corner on COVID-19 with widespread vaccine availability and rapidly declining rates of new infections. We dared to dream about what a post-COVID-19 return to normalcy could look like. And then the delta variant arrived bringing a frustrating and sustained rise in new cases across the world. With all the loss that so many had experienced already from COVID-19, could we maintain our collective resolve in the face of this significant setback?
Fortunately, as summer turned to fall, we witnessed the resilience of the human spirit. We were better prepared as a nation this time to handle this delta variant surge, although our progress has certainly been uneven. We benefited from higher vaccination rates, generous federal stimulus programs that lifted consumer spending across the income spectrum and a return to in-person schooling for most that helped both children and families re-establish routines.
Through all these ups and downs, U.S. and global equity markets posted strong returns over the past 12 months. Value stocks led growth over the one-year period but lagged over longer time periods. Similarly, small caps outperformed large caps, while large caps continued to lead over longer time periods. In contrast, bond markets faced headwinds from rising interest rates, pushing Treasury bonds and the Bloomberg U.S. Aggregate Bond Index into negative territory. Corporate bonds were a lone bright spot, managing to post positive results for the fiscal year.
Investors continue to seek income wherever they can find it in today’s low-yield environment. However, over the course of the past year, interest rates have been increasing, with the 10-year U.S. Treasury yield more than doubling since it bottomed in August 2020. Rising rates have been in response to the likely prospect of the Fed beginning to taper its asset purchases soon, and potentially raising rates by the middle of 2022.
As we close out fiscal year 2021, there are four significant issues that must be addressed going forward: the supply shortages stemming from burgeoning consumer demand and supply-chain disruptions, ongoing labor shortages, rising prices (and the specter of inflation), and the persistence of the Delta and other potential new variants.
Harbor believes that the trajectory of the economic recovery will remain uneven for the foreseeable future, given the headwinds mentioned above. That’s why it’s so important for investors to focus on practical solutions to manage inevitable market volatility. Drawing upon the expertise of experienced, active portfolio managers is one way to help investors to achieve their long-term investment goals. We’re confident that Harbor together with our investment partners will continue to execute our strategies in a disciplined and thoughtful manner to benefit shareholders over the long haul.
In fact, we believe that a challenging and volatile market environment is actually good news for active managers, because it allows us to add potential value and pull ahead of the pack. Our research shows that the difference between top-performing and bottom-performing active managers, across major asset classes from U.S. large cap and small cap to foreign large cap and emerging markets, is at its highest level in 20 years
I hope you and your families will fare well over the coming year. Thank you for your confidence and continued investment in Harbor Funds.
December 21, 2021
Management’s Discussion of Fund Performance
MARKET REVIEW
This fiscal year marked the recovery from the COVID-19 lockdowns in the U.S., with announcements around a full vaccine rollout at the start of the period boosting investor confidence and contributing to a stair-step rally that lasted the full year. The market responded to the rebound in economic activity and near-record earnings growth. All of the major U.S. stock indices ended the period at all-time highs.
PERFORMANCE
Harbor Capital Appreciation Fund advanced 41.33% (Retirement Class), 41.22% (Institutional Class), 40.86% (Administrative Class) and 40.71% (Investor Class) in the year ended October 31, 2021, while the Russell 1000® Growth Index, returned 43.21%. The S&P 500 Index returned 42.91%.
All sectors in the growth benchmark posted positive returns in the period. Information Technology, Communication Services and Consumer Discretionary were the most important contributors to the Fund’s returns.
Tesla (TSLA, Financial), the top contributor to the Fund’s return over the period, is a name held in the Fund since 2013. The company continues to exceed expectations around production, deliveries and profit margins, yet we believe the opportunity for scale and consistent margin improvements is not fully reflected in the market. We believe Tesla will capture an important share of the rapidly accelerating demand for electric vehicles globally over the next several years.
A number of the Fund’s top ten holdings in the Information Technology sector have posted record results over the past year, as the digitization of the economy accelerates, demand patterns shift in favor of e-commerce, and enterprises migrate a growing share of their business functions to the cloud. Nvidia (NVDA, Financial), the leader in advanced graphics chips and a holding since 2016, is benefiting from strong secular growth across a number of business lines, including datacenter, automotive and gaming, and the company’s results have repeatedly exceeded consensus estimates this year. Microsoft (MSFT, Financial) and Alphabet (GOOGL, Financial), stocks we have held in the Fund for several years, were the strongest performers among the mega-cap tech names, on impressive growth and profitability in their diversified portfolios of consumer and enterprise businesses. Shopify (SHOP, Financial), a Fund holding since 2019, is a Canadian-based SaaS (Software as a Service) company facilitating e-commerce for nearly two million merchants and an important beneficiary of the drive to establish an online direct-to-consumer presence. The company’s customers range from small- and medium-sized businesses up to some of the world’s largest consumer brands.
That said, not all of the Funds’ investments have gone as planned. In those cases, our goal is to mitigate the negative impact of the positions that don’t work out. We achieve this through our practice of cutting our exposure to a stock once we recognize that company or industry fundamentals are trending in the wrong direction or if we have reason to question our confidence in multi-year forecasts.
This was the case with Chinese gaming and e-commerce giants, Tencent (HKSE:00700, Financial) and Alibaba (BABA, Financial) during the period. The cancellation of the IPO of Alibaba affiliate Ant Financial, late last year and a series of regulatory actions against a number of large companies undermined sentiment and led to a significant sell-off in Chinese stocks. As fundamental investors focused on long-term growth and profitability, we are not comfortable with the lack of visibility and the risk of further government action. Therefore, the Fund exited both Tencent and Alibaba and ended the period with no direct exposure to Chinese stocks.
OUTLOOK & STRATEGY
Investors are facing a complex landscape heading into the final months of 2021 and into 2022. Profit growth has been exceptionally strong for the market overall, yet many companies have more recently reported pressures from rising wages and supply chain bottlenecks.
We believe corporate profit growth will return to pre-COVID-19 trend levels over the course of next year. While these levels are respectable in absolute terms, they represent a meaningful slowdown from the COVID-19-driven highs reached over the past 18 months.
We remain optimistic that the Fund’s holdings are well-positioned to navigate this complex landscape. In our view, the Fund is widely invested in companies with market-leading positions, strong cash flow generation and often-disruptive business models that should allow them to deliver superior growth longer than the market currently expects.
1 Retirement Class shares commenced operations on March 1, 2016. The performance attributed to the Retirement Class shares prior to that date is that of the Institutional Class shares. Performance prior to March 1, 2016 has not been adjusted to reflect the lower expenses of Retirement Class shares. During this period, Retirement Class shares would have had returns similar to, but potentially higher than, Institutional Class shares due to the fact that Retirement Class shares represent interests in the same portfolio as Institutional Class shares but are subject to lower expenses.
This report contains the current opinions of Jennison Associates LLC as of the date of this report and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Such opinions are subject to change without notice and securities described herein may no longer be included in, or may at any time be removed from, the Fund’s portfolio. This report is distributed for informational purposes only. Information contained herein has been obtained from sources believed reliable, but not guaranteed.
There is no guarantee that the investment objective of the Fund will be achieved. Stock markets are volatile and equity values can decline significantly in response to adverse issuer, political, regulatory, market and economic conditions. Since the Fund may hold foreign securities, it may be subject to greater risks than funds invested only in the U.S. These risks are more severe for securities of issuers in emerging markets regions. For information on the different share classes and the risks associated with an investment in the Fund, please refer to the current prospectus.
