Mutual-fund investors must be true believers. Even as stocks swung wildly last year, battered by the worst bond market since the Great Depression, investors in equity funds remained undaunted. Although cash inflows ebbed toward yearend, the final tally will likely be the second-highest on record. And 1995 is off to a strong start, too, says Robert Adler of AMG Data Services. Cash is coming into equity funds at the rate of $2 billion a week.
Sure, 1994 was a dismal year for equity funds. The major stock indexes finished the year slightly on the plus side, but the average total return for equity funds was -1.8%, including dividends and capital gains. And that's before taxes, which could have eaten up an additional two percentage points.
Will equity-fund investors bolt, as some bond-fund investors have already done? Not likely. Veteran mutual-fund analyst A. Michael Lipper of Lipper Analytical Services Inc. says investors need to amass capital to pay for college or retirement. "In the long run, these needs are better met with significant investment in equity funds" rather than fixed-income funds. Over the past five years, which include two down years, 1990 and 1994, funds still earned, on average, 9.1% a year. The 10-year average annual return--which includes the 1987 crash--is even better, 13.1% a year.
But that doesn't mean that investors will, or should, stay with the same funds year in, year out. Portfolio managers move on, investment policies change, fees rise. Or the investors' own objectives, preferences, and tax status change. And sometimes investors must switch because a fund just loses its way.
That's where the BUSINESS WEEK Mutual Fund Scoreboard can help you plan your investments and monitor just how your funds are faring. This year's Scoreboard has been expanded to include detailed information on 885 equity funds, 125 more than last year. Next week, BUSINESS WEEK will publish expanded listings with 652 bond funds, many of which suffered large redemptions as investors learned that bonds can be more risky than equities. In two weeks, BW analyzes 260 closed-end funds, some of which are selling at large discounts and offer juicy returns. The Scoreboard is compiled for BUSINESS WEEK by Morningstar Inc.
The equity-fund Scoreboard that begins on page 114 includes the critical data you need to measure mutual-fund performance. For each fund, we show total return, both pre- and aftertax, for the past year and, depending on their history, 3-, 5-, and 10-year figures. We compare a fund's performance against funds with similar investment objectives. We look at the costs of buying and remaining invested in a fund.
RISKY? Then we go inside each fund to show how it invests. We analyze the "investment style." Does it purchase large-capitalization growth stocks or small-cap value stocks? Does it buy stocks with high price-to-earnings ratios? We also tell you how much cash the fund is sitting on.
And most important, we measure just how much risk the fund manager is taking. The Best Mutual Funds are not always the ones that have posted the plumpest returns. The best are those that have earned the highest reward for the amount of risk they took with your money. That's why the BUSINESS WEEK Scoreboard awards ratings to mutual funds based on their risk-adjusted total returns. And because fund investing is a long-term proposition, we do not rate funds until they have logged a five-year track record.
This year, 47 funds earned three upward-pointing arrows, the highest rating, and they are a diverse lot (table). Some of them, such as AIM Aggressive Growth, Hancock Special Equities, PBHG Growth, and Seligman Communications & Information Fund take on high risk, buying the shares of rapidly growing companies at high p-e ratios.
That can lead to some wild rides. Just look at the Seligman fund, which specializes in technology stocks. The fund was the best performer both for 1994, up 35.3%, and for the five-year period, an average annual return of 24.2%. Yet it's not for the faint of heart. From March to June of last year, the fund lost 22% of its net asset value. But the beauty of the BW ratings is that funds don't have to take high risks to win accolades. At the other end of the spectrum, there's Flex-funds Muirfield, Gateway Index Plus, Lindner Dividend, and Merger Funds. Each of these funds beat the market by a percentage point a year or less. That may not sound like much until you consider that the risk rating of each of these funds is "very low" and that of the stocks in the Standard & Poor's 500-stock index is "average." If a fund can deliver a little more return at a lot less risk, it's worth lauding. Such funds should appeal to investors who should be in equities but are reluctant to bear the day-to-day volatility of the stock market.
These top funds all take different approaches to investing. Lindner Dividend focuses on generating high yields and Gateway on selling options. Perhaps most unusual is Merger Fund, which, true to its name, invests in companies after a merger agreement is announced. The strategy is not without risk--deals after all do fall apart--but that risk is not correlated with that of stock market. "Strategic deals that make sense get done even in an unfavorable market," says Fred Green, who with Bonnie L. Smith manages the fund. Last year, the fund earned a 7.1% total return.
Not all of the top-rated funds beat the market during 1994. Most funds that held some bonds--mainly asset-allocation, balanced, and income funds--were pulled down by those holdings. But in 1993, they were golden as rates fell and bonds surged in value.
Although Merrill Lynch Global Allocation B Fund and Fidelity Asset Manager retain their top ratings, they failed to beat the S&P in 1994. Both funds have wide latitude to invest at home or abroad, yet neither came up with a winning mix. The Merrill fund suffered a -2.9% return. The Fidelity fund, -6.6%, was dragged under by its holdings in emerging markets, a source of plump returns in previous years. "I was lowering emerging-markets holdings all year, but I didn't get to zero soon enough." says Robert A. Beckwitt, who runs Fidelity Asset Manager. The fund is down 1.3% so far this year.
DREARY SHOWING. International investing lost most of its luster in 1994. About the only market to make gains was Japan's--and a scant few fund managers had invested there. And though the Mexican currency crisis that began in mid-December contributed to the dreary performance abroad, the international funds were not faring particularly well until then either. Even Founders Worldwide Growth Fund, the only world fund to get a top rating this year, recorded a -2.2% return in 1994. But fund investors have not lost their appetite for overseas investing. Last year, international funds took in 37% of the inflows to stock funds, according to Avi Nachmany of Strategic Insight Inc., a fund-industry consulting firm. But AMG's Adler senses a slowdown--so far this year, only 10% of the new money is going global.
With jittery markets, it was no wonder fund managers had a tough time getting any positive results. But even funds with a bearish bent, such as the Robertson Stephens Contrarian Fund, fared no better. Anticipating higher inflation, the fund loaded up on gold, metals, and energy stocks and sold short popular highfliers, betting on a big market plunge. The fund had a 5.5% loss for the year.
"It was a year in which almost nothing worked," sighs Jean-Marie Eveillard, portfolio manager of the Sogen International Fund. "Even gold didn't pan out." Gold bullion and gold mining shares had soared in 1993, but in 1994, precious metals funds were the worst performers, down 9.2%. Eveillard managed to eke out a 2.5% total return for the year, mainly because of some shrewd stock picks and a pile of cash.
Funds that invested in low p-e and low price-book stocks--so called "value" stocks--fared better in the first half of 1994. Those that bought higher p-e "growth" stocks did better in the second half. This reversal in the trend explains why, overall, the results of the various investment styles as shown on page 112 are not significantly different from one another. But investment style will make a difference this year. If the economy slows, as most expect, funds with a growth-stock tilt should shine. True "growth companies" don't need a robust economy to generate profits.
As a matter of policy, many funds keep most of their money invested in stocks, not allowing cash to pile up. But those that could and did keep cash delivered relatively strong performances. Anthony G. Orphanos, portfolio manager of the top-rated Warburg Pincus Growth & Income Fund, up 7.6% in 1994, took profits in technology stocks during the summer and has had 40% of his fund's assets in cash since Labor Day. Orphanos is in no hurry to spend it. To become bullish again, he says, "I have to see evidence that the economy will slow precipitously or long-term interest rates would have to fall below 7%."
LET IT RIDE. Mark G. Seferovich, who runs the United New Concepts Fund, says his cash cushion, now 27%, helps to dampen the swings inherent in portfolios of small-company stocks. And he doesn't consider cash to be a drag during bull markets either. "In an up market, stock selection will overpower the weight of cash any day," says Seferovich. He's also happy to let his profits ride. The 10 largest holdings, including motorcycle manufacturer Harley-Davidson Inc., have been in the fund since 1990. He earned a snappy 11.3% last year, and 19.9% over the past five years. That helped him win three up-arrows in the BW Scoreboard.
At the Flex-funds Muirfield Fund, cash is not a cushion but a strategic weapon. Manager Robert S. Meeder Jr. moved to all cash last March and stayed that way until yearend. Now, he has put most of that money back to work. The fund has 50% of its assets in equities--which in Muirfield's case is other equity funds. Its largest holding is Fidelity Capital Appreciation Fund, 6% of assets. Others include Fidelity's Blue Chip and Growth & Income funds, as well as Neuberger & Berman Focus and T. Rowe Price New Horizons funds. And 20% of the fund is in 10-year U.S. Treasury bonds.
Technology funds were the big winners in 1994--and so were those diversified funds that banked heavily on high tech, such as Fidelity Blue Chip Growth Fund. The entire sector of the market benefited from increased capital spending on productivity-saving technology and on the public's growing appetite for gadgetry such as PCs and cellular phones.
After four years of strong performance, can you still bet on technology? "Sure, we have a lot of technology," admits Michael Gordon, Blue Chip's manager. "But we talk to the companies all the time, the business prospects are great, and the stocks are not expensive based on their growth rates."
Nonetheless, fund analysts generally warn investors not to chase the top-rated specialty funds such as the Fidelity Selects: Computers, Electronics, Software & Computer Services, and Technology. "Usually, the point at which everything looks great about a sector is the time you have to worry about getting out," says Don Phillips, publisher of Morningstar Mutual Funds. Phillips suggests buying more diversified funds that can invest in technology and leaving the specific technology sectors to the portfolio manager's expertise. The average growth fund already has 20% of its assets in technology, and some small-cap growth funds more than 30%.
Smart mutual-fund investing takes work. And the place to get started is the BUSINESS WEEK Scoreboard tables. The funds are listed alphabetically, and if they accumulated a five-year record, their BW rating follows the name. Also, be on the watch for a head-and-shoulders icon. The solid icon indicates a portfolio manager with 10 years at the helm. A head-and-shoulders outline means there's a new manager on the job.
MUSHROOM. The next column, "Assets," is the fund's size. Fidelity Magellan Fund notwithstanding, performance often slows as funds grow. Check out Crabbe Huson Equity and Crabbe Huson Special Funds on page 116. Both funds rate three up-arrows. Because of that performance, the Crabbe Huson Special Fund in particular has mushroomed--its assets were up 1,200% over the last year. Most of the fund's admirable record was amassed when it was a mere fraction of its current size.
Portfolio manager James E. Crabbe says neither the Special fund nor the Crabbe Huson Equity, run by partner Richard S. Huson, will have any trouble finding investment opportunities. "We buy stocks that are down 40% to 50% over the last 24 months, and there's no shortage of those," says Crabbe. The key, he adds, is to determine which of the depressed stocks can rebound in the next year or two. For instance, they started buying IBM at 46 when Big Blue was flat on its back. Today, it's at 74. Crabbe's next high-tech comeback bet is Cray Research Inc., down from 50 to 15. His firm holds 5% of the company and believes it's at least a double.
Moving to your right along the Scoreboard, you'll find fees, both sales charges--often called "loads"--and expense ratios, which is the annual cost of keeping your money in the funds. The average expense ratio is 1.29%, or $1.29 for every $100 in the fund. The higher the expenses, the more it eats into your returns. And that's a cost to be borne whether or not the fund makes money.
Next comes the 1994 returns, both pretax and aftertax. Yes, investors in mutual funds may still be stuck with a tax bill even if the fund didn't make any money during the year. Here's why: By law, the fund must distribute its net income--that shows up in the "yield" column--as well as any realized capital gains. So even if net asset value fell, there may be some taxes owed.
SHARP PAIN. Look at Twentieth Century Growth Investors on page 138. The pretax return for 1994 was -1.5%, a little better than the average equity fund. But this fund also made large capital-gains distributions amounting to about 15% of NAV. After taxes, the fund's return dropped to -5.6%. That would have been particularly painful to new investors in the fund, who didn't have their money invested long enough to take advantage of the portfolio's long-term gains. "It's like arriving at the party as it's breaking up and getting stuck with the caterer's bill," says Morningstar's Phillips.
Can you guard against being blindsided by large capital-gains distributions? Not entirely, but there are some tip-offs. Is the fund's asset base shrinking? You can tell that from the "% chg." column under assets. That could mean more money is coming out than going in, and managers may have to cash in some winners to meet redemptions. A new portfolio manager may also offer a clue. He may sell stocks--and unlock unrealized gains--to recast the portfolio to his own liking. Are there unrealized gains in the fund? You can find that out on the right-hand pages under the column "Untaxed Gains." Right now, Twentieth Century Growth's untaxed gain is small, only 7% of the portfolio. But a year ago, that figure was 22%.
In that same column, you'll also note many negative numbers. That means the fund has more unrealized losses than gains in the portfolio. That could be a tax shelter. The fund can't distribute losses to shareholders, but it can use them to offset future gains and avoid taxable distributions. Of course, buying a fund rife with losses means you're buying a loser--so you better be confident the fund can make a comeback.
Balancing all these analytics is not simple. But if you're a serious mutual fund investor, it's the only way to be sure that you and your fund are made for each other.