Personal Business: Mutual Funds
CAN YOUR FUND PASS THESE SECURITY CHECKS?
The mutual-fund industry, long praised for remaining scandal-free, this year has been plagued with bad publicity. Portfolio managers have been called to task for conflicts of interest and investing in risky securities that generated startling losses. Some fund sponsors were reprimanded for misleading advertising and for errors in reporting prices and allocating trades. This steady stream of bad news is disquieting for investors who may be realizing mutual funds aren't immune from ethical breaches.
HAND-WRINGING. But if you're starting to wonder if you can trust your mutual fund, a wealth of information is available to help you assess your holdings. Keep in mind that regulations governing funds allow little opportunity for outright fraud and--although funds can lose money--it is virtually impossible for them to go bankrupt the same way a company can. Fund sponsors have responded swiftly to squelch improprieties and regulators are expected to beef up their monitoring apparatus, which they admit has not kept pace with industry growth. Even the trade group, the Investment Company Institute (ICI), has pushed for tougher rules and more regulatory oversight, realizing that a few rotten funds could spoil the whole barrel.
So far, investors in funds that have run into trouble have emerged relatively unscathed. For example, much of the concern over conflicts of interest was touched off when Invesco Funds Group fired one of its star managers, John Kaweske, in January for failing to comply with its personal trading rules. The ICI responded by creating a panel that recommended tougher rules, and companies gladly agreed to step up compliance. Despite the hand-wringing over Kaweske's trading, investors in Invesco Industrial Income, the fund he managed, can boast a 10-year average annual return of 16.8% through July.
And, while money-market funds run by BankAmerica, Fleet Financial, and others lost money due to use of inappropriate derivative securities, the companies bailed out the funds so investors wouldn't suffer losses. The Securities & Exchange Commission followed up by warning all money-market funds to stay away from exotic derivative holdings.
Even the latest high-profile fund fiasco is not as frightening as it seems. Piper Jaffray's Institutional Government Income Portfolio, which has a $25,000 minimum, has fallen 23.5% this year through July, largely due to investments in collateralized mortgage obligations and securities derived from them. But the fact that this fund contained mortgage-backed securities was well-known. The fund enjoyed twice as high a return last year as many of its competitors--a red flag that its manager was taking extra risks. As a show of confidence, Piper Jaffray invested $10 million in the fund in May and then closed it to new investors so existing ones could benefit from any share price improvement. The company also ran a letter from its chairman in some newspapers responding to criticism, and listed a toll-free number to call for further explanation.
COMING CRISIS? These and other problems have been important for industry professionals and regulators to tussle with. But even if the implications for individual investors have been mild, that's not to say there won't be more problems down the line. Fund managers are getting more speculative, and sponsors more aggressive, says Donald Christensen, author of Surviving the Coming Mutual Fund Crisis ($22.95, Little, Brown and Co.). As scandals inevitably erupt, investors will grow disillusioned, abandoning mutual funds, he says. Despite his doomsday view, Christensen admits: "You can be in mutual funds and survive what I consider to be the crisis."
To improve your chances, you need to be vigilant about the funds you pick. That means following advice you've been hearing for years: Know the manager, understand the investment strategy, don't take more risk than you can handle. Review your choices at least once a year to make sure the management or strategy has not changed.
Indeed, some funds have gotten riskier as the financial world has grown more complex and competitive. For example, that aggressive fund you bought three years ago may be purchasing illiquid securities such as private placements, Third World debt, or mortgage derivatives. Or it may be using leverage or commodity futures.
NEW BREEDS. Some funds, such as American Heritage and Robertson Stephens Contrarian, have gotten so speculative that in a recent editorial, Morningstar Mutual Funds called on the industry to distinguish them from the rest of the mutual fund world. "Investments that didn't even exist a few years ago, or ones that historically have been the domain of hedge funds or venture-capital pools, are finding their way into the portfolios of mainstream America," Morningstar warns.
The derivative losses in a few money-market and short-term bond funds show that even conservative funds may invest in ill-suited securities. For the last 10 years, the fixed-income fund arena has been a graveyard of failed concepts, including option income funds, government- plus funds, and multimarket funds, says Don Phillips, Morningstar's publisher. Choose funds that employ tried-and-true strategies and have at least a three-year track record.
If a fund has exceeded your comfort level for risk, you may want to gradually shift into a more conservative offering. But don't panic or you may sell at the worst time. Illiquid investments can cause the share price to jump around. But that doesn't mean they won't pay off handsomely for investors who can tolerate the volatility. By sticking with plain-vanilla funds, you may miss out on some of the more rewarding investments managers have discovered.
You can get a snapshot of the holdings by reviewing the annual and semiannual reports, but the funds don't make it easy: You won't find the word "derivative" used, and judging securities listed as "collateralized notes" or "indexed securities" is too tough for anyone but the pros. The investment summary and market performance analysis in these reports often will be more useful.
The fund's prospectus includes an investment policy statement, which outlines the overall strategy, lists what the fund can and cannot do, and highlights specific risks. But even if the prospectus says the fund can sell short or use commodity futures, you'll have to ask the company if it really intends to do such things. For legal reasons, charters of new funds may allow them to engage in virtually all investment practices, even ones the fund has no intention of using, says Phillips. Many funds ask shareholders to approve changes to their charter, allowing them to make more speculative trades. Review proxy statements to be sure the fund company isn't trying to change the bylaws, letting the manager use riskier strategies.
If you don't want to wade through all those documents, performance can offer an important clue about the manager's course. If your fund is returning substantially more than its peers, it is probably taking on more risk. Conversely, if a fund has declined much more than others in its category, it may be getting punished for speculating.
THE RIGHT STUFF. Individuals should make sure they have faith in the integrity of the fund company. Complicated fee structures and misleading advertising can be signs that the fund is overly hungry for investor dollars. If a fund you own is the subject of negative publicity, watch to see if the company responds swiftly to accusations.
When it all boils down, there is an element of trust involved in mutual-fund investing. If you're worried about your holdings now, you might wish to choose a portfolio manager who has weathered a bear market. Another way is to deal only with large, reputable companies such as Fidelity, Vanguard, and Dreyfus.
All the scrutiny that mutual funds are getting from the industry, regulators, and the media should be reassuring. "On the whole, this is a healthy process," says Phillips. "In the end it uncovers more useful information for investors." Now that you know some of the things that can go wrong, use the information to make certain the funds you buy don't veer too far off course.
FERRETING OUT PROBLEMS IN MUTUAL FUNDS
-- Has the fund company been the subject of negative publicity that makes you question its integrity? How did the company respond?
-- Did the advertising prove to be misleading once you reviewed the fund's investment strategy, fees, and past performance?
-- Does the fund invest in illiquid securities, such as mortgage derivatives, restricted stocks, or debt of Third World countries?
-- Does the prospectus allow the fund to engage in any speculative trading practices, such as those employing futures or options, buying on margin, or short-selling? If allowed, does the fund do such things?
-- Is the fund company asking permission to raise its fees or expenses or to use riskier investment strategies? Watch the proxy statements.
EIs the fund's performance consistent with similar funds? If your fund is a stellar performer, make sure it's not taking undue risks.
DATA: BUSINESS WEEK
SOME HIGH-PROFILE FUND FOIBLES
JANUARY 1994 Invesco fired one of its star managers for failing to comply with its rules on personal trades, setting off an industrywide effort to toughen compliance systems.
MAY The head of Pilgrim Group was disciplined by the National Association of Securities Dealers for misleading advertising.
MAY Piper Jaffray's Institutional Government Income Portfolio fell 24% because of losses in mortgage derivatives. Piper invested $10 million in the fund as a show of confidence.
JUNE Fidelity Investments reported incorrect share prices on its mutual funds after a day when most funds dropped in value. Fidelity apologized, and the deadline for reporting prices was extended.
JUNE AND JULY BankAmerica spent about $68 million to bail out two money-market funds that lost money because of derivatives trading. Other fund groups made similar moves to protect shareholders.
JULY Strong/Corneliuson Capital Management settled regulators' complaint over pricing problems and trading between funds from 1987 to 1990. Strong agreed to reimburse funds for pricing errors.
DATA: BUSINESS WEEKAmey Stone By EDITED BY AMY DUNKIN