The Mayhem In Mutual Funds

It's the year of atonement for owners of what used to be called high-growth mutual funds. Some of those funds are off by 30 percent or more, shocking investors to the core. Mutual funds have a rep for being stodgy but safe. At worst, you expect mediocre performance, not an outright dump. Some so-called low-risk funds have disappointed, too.

Investors too often take funds on faith. You go by the name ("ah, a utilities fund"). Or maybe an ad ("mmm, five stars from Morningstar"). Or a magazine cover ("oooh, a top manager for 2001"). Few investors bother to look at what a fund actually owns. Even fewer know what they'd be looking for.

Oddly, funds are often treated as a special-investment class. People will say, "I have stocks, bonds and mutual funds." But mutual funds are stocks and bonds--baskets of them, in various mixes. How well they do depends on what they buy. A fund may or may not be diversified. It may or may not behave in the way its name implies.

Take utilities funds. To most investors, "utilities" means "conservative." They think of regulated companies paying dividends and delivering heat and light. But please--wake up and smell the steam. Utilities can be Wild West, with performance stretching from near bankruptcy in California to go-go growth in natural gas and wholesale power generation. You can't be just a utilities investor. You have to know which kinds of utilities a fund manager buys and form an opinion about them. In other words, industry research.

Which utilities: Two funds tell the story. The new Gabelli Utilities fund buys gas and electric companies that it thinks are takeover targets. Last year its price jumped 16.4 percent. At the same time, Fidelity Utilities lost 20.5 percent. Its manager gambled on telecommunications stocks, which had a rotten year. I wonder how many Fidelians knew they were hitched to such a speculative sector. You had to watch what the fund was buying, read the manager's reports and think about the risks--things fund investors normally don't do.

And how about balanced funds that hold both stocks and bonds? You think of them as diversified, but Fifth Third Balanced is 44 percent in technology stocks. In the "equity income" group, people aren't seeing a lot of income, largely because fewer stocks pay decent dividends. Chase Vista Equity Income Fund currently yields a big, round 0.00 percent, with its 1.8 percent dividend all but swallowed by expenses. Then there are "aggressive growth" funds like Janus Twenty, steeped in high tech. You thought it was super stockpicking that gave Janus such a boost in early 1999. Instead, it was mostly the tech bubble passing through. Since then, the fund has more than given up its gains. Except for the thrill, you'd have been better off in an index fund that merely invested in all the stocks in the S&P.

The fund industry also pitches a swarm of new offerings every year. You'd think that the 4,400 stock funds we already have would be choice enough. But an additional 858 registered in 2000, FundFiling.com reports. The newcomers reflect what the industry thinks it can sell. That means touting managers who happened to outperform last year, airy concepts such as "global leaders," and niches that sound fresh. Among Fidelity's Focus funds, sold by financial advisers, there's a fund for "electronic components" and one for "developing communications." The Pilgrim group registered a fund for "global communications."

But why would you even want to go there? The original genius of mutual funds was diversification. Instead of exposing yourself to the risk of just a few stocks, you could spread your money across the entire U.S. economy. In more recent years, investors sought more control by dividing funds into classes, such as value and growth. Growth stocks (showing fast-rising revenues or earnings) do better when business expands, says James Bianco, consultant to the Leuthold Group, a Minneapolis stock-research firm. Value stocks (those beaten down in price) show up better in times like these, when business slows.

But for good results, how thinly do you really have to slice the baloney? I could fill a page with the classes of funds that exist today. We've got midcap value, microcap, big-cap growth, small-global-value, blah blah blah. My personal favorite is something called "all-cap growth and value," which could cover any stock at all. I doubt that these fine distinctions do much for individual investors except confuse them. To most of us, mid-cap might as well be a skirt length.

Inevitably, leading stock groups fall back and laggards catch up. The BARRA growth-stock index dropped 14.1 percent in the past 12 months while the value-stock index gained 14.2 percent. Value-fund managers didn't suddenly go from dumb to smart. They were just sitting in the road when the market turned their way.

A nutshell: There, in a nutshell, lies the case for diversification. Truly diversified funds include out-of-favor stocks that pop up when nobody is looking. They cover niche businesses that brokers try to sell you separately for a price. You get some global leaders and some developing communications in appropriate amounts.

Funds that say they diversify have to follow certain rules. For example, they can put no more than 25 percent of their assets into a single industry. Unfortunately, that 25 percent can be in a single stock, provided that the rest of the money is suitably spread around. So check it out. Diversified funds aren't necessarily well diversified. You'll find the kinds of stocks the fund holds in the manager's latest report. The list is out of date but the best you can get.

Some investors pay advisers to choose their funds. But you can do it yourself if you don't get fancy. "Just buy plain growth and value without worrying about the rest," says Sheldon Jacobs of the No-Load Fund Investor in Ardsley, N.Y. Planner Harold Evensky of Coral Gables, Fla., keeps half of his clients' money in index funds.

New investors can't be faulted for thinking that only grannies diversify. But that was before the Nasdaq crashed. There's no excuse the second time you're kicked by a mule. The basics need a place in your heart, if you hope to make it to retirement unbruised.