To say that investors are wild about mutual funds is like saying Tiger Woods can putt. In 1996, some $223 billion was handed over to equity-fund managers--$28 billion more than all the money in equity funds only eight years ago. It's almost as much as the gross domestic product of Sweden.
That megabuck stream may look to some like "irrational exuberance." Far from it: In the long run, stocks have delivered the best results of any investment. And there's no question that, for most people, mutual funds are a simpler and more cost-effective way to invest than doing so on their own. "It's a rational move--especially since more than half the cash comes from 401(k)s, IRAs, and other forms of retirement savings," says Avi Nachmany of mutual-fund consultants Strategic Insight.
Today, the average investor owns three funds, according to Investment Company Institute, the funds' trade group. But 43% of fund investors have four or more, a figure that jumps to 56% for the more active investors, who buy direct from fund companies or through discount brokers. "I just can't imagine myself with fewer than 20 funds," says Kent C. Shellady, 42, a sales-and-marketing executive from Cur d'Alene, Idaho. Shellady chooses funds he thinks are the best investors in various segments of the stock market.
HAPHAZARD. But many investment advisers say they've counseled hapless investors who have amassed large numbers of funds--30 or more--with no apparent rationale in mind. The common denominator in such portfolios is that most of the funds were purchased after they had just gone through a burst of chart-busting performance and a blaze of publicity in the financial media. The problem with such multifund portfolios, they say, is that these investors wind up with less diversification, more risk, and possibly fewer profits than they might have.
It's time for fund investors, well, to take stock of their portfolios. Do you know how the fund managers are deploying your dollars? Even more important, do you own a hodgepodge of funds or a finely tuned portfolio with a game plan and an ultimate financial goal? Just because you've assembled a group of virtuosos doesn't assure a boffo performance--unless you have the right instruments, music, and conductor.
BUSINESS WEEK's Mutual Fund Scoreboard can help your portfolio earn rave reviews. The 12th edition of our equity-fund scoreboard carries all the critical information you've come to expect--and more. We have total-return data on 885 funds: performances over 1, 3, 5, and 10 years, both before and after taxes; sales charges and expense ratios; and, of course, BUSINESS WEEK's mutual-fund ratings for risk-adjusted performance. Those ratings, the highest of which is three upward-pointing arrows, evaluate all funds with at least a five-year track record. The Scoreboard data are prepared for BUSINESS WEEK by Morningstar Inc.
In this performance guide, we've made improvements to help you gain a better understanding of your funds, assess their performance more accurately, and judge whether your funds duplicate or complement each others' efforts.
We've also changed the way we classify funds. The old objectives for domestic equity funds, such as "growth" and "growth and income," are out. Instead, these funds are sorted into one of nine categories. Each category is characterized by median market capitalization of the stocks in their portfolios and the kind of stocks they buy. For instance, a fund that's "large-cap value" is one whose stocks have a median market cap of $5 billion or more and are also "value" stocks. To be a value fund, the fund's combined price-earnings ratio and price-to-book-value ratio must be significantly below that of the Standard & Poor's 500-stock index. Among those in this category: Fidelity Equity-Income and Vanguard/Windsor.
At the other end of the spectrum, "small-cap growth" is the category for funds with median market caps less than $1 billion and with p-e's and p-b's above the average. Some funds in this category are Acorn and Baron Asset. Funds with market caps between $1 billion and $5 billion are mid-cap. Those whose portfolios' p-e's and p-b's hover around average are "blend" funds. Giant Fidelity Magellan Fund sits right in the middle of middle--a mid-cap blend.
With these new tools, plus the Scoreboard in hand, you're ready to analyze your portfolio. Here's how:
-- What do you have? Take the most recent account statement for each of your funds. In the newspaper fund tables, check the net asset value per share and calculate the value of each fund. Don't forget to include funds held in individual retirement accounts and 401(k) plans, as they're part of your financial picture, too. Divide the dollar amount of each fund by the value of the entire portfolio. That tells you what percentage of the entire portfolio is in each fund, which is critical for the next step.
-- What categories of funds do you own? For domestic equity funds, look to the nine-box style grid (right), which, from top left to bottom right, goes from large-cap value to small-cap growth funds. Look up your funds in the Scoreboard to find which category they're in. When you're finished, calculate the amounts you have in each category, such as 15% in small-cap value or 20% in mid-cap growth.
Most of your funds will fit into these boxes. But not all. International funds are categorized differently. Most are "foreign" or "world" funds--the main difference being that foreign funds generally do not hold U.S. stocks, while world funds do. Diversified emerging markets take in the funds that invest in less mature stock markets of the developing world. Regional funds include Europe, Latin America, Japan, and two other sorts of Pacific funds--those that include Japan and those that don't. Specialty funds are categorized by their respective sectors, such as technology, financial, or real estate.
Funds that mix stocks, bonds, and perhaps other assets are either domestic hybrids--unless they include non-U.S. securities, which makes them international hybrids. If you own any of these funds, you should check your recent reports or call the fund company to find the allocations of stocks and bonds and if possible, what categories of stocks and bonds they belong to.
Bond funds have new categories, too, organized by the type of bonds--corporate, government, or municipal--and the maturity of the bonds they hold in their portfolios. (We'll introduce them in the Bond Fund Scoreboard next week.)
-- What's your investment horizon and your risk tolerance? In general, the younger you are, the longer your investment horizon--and the more equities your portfolio should have. Thirtysomething fund buyers are at least 30 years before retirement but perhaps only 10 to 15 years away from their kids' college expenses. And the longer your horizon, the more equity you need. John Markese, president of the American Association of Individual Investors, suggests that even retirees should keep at least half their money in equities.
How much you allocate to equity funds also depends on your tolerance for risk, or volatility in the value of your portfolio. Look at the "Cranes," a couple in their early 40s who sought the assistance of Lou Stanasolovich of Legend Financial Advisors Inc. in Pittsburgh in restructuring their portfolio (table). Through IRAs, Keogh plans, and other mutual-fund investments, they had accumulated a portfolio that was more than 80% in equities.
Like many other investors who came to funds during the 1990s, the Cranes had never seen their investments mauled by a bear market. When Stanasolovich showed them what had happened to their funds during the 20% market decline in 1990, they decided to pare their equity allocation to 60%. "People their age could easily go to 75% in equities," says Stanasolovich. "But you also have to be comfortable with your portfolio."
In trying to dodge stock market volatility, some investors flee to bond funds. But they're not risk-free, either. Bond funds can get clobbered by rising interest rates. Cincinnati investment adviser Michael C. Hengehold of Hengehold Capital Management Inc. recently revamped, for a newly retired couple, a $1.4 million portfolio that was 65% in bond funds and income-oriented equity funds into one that's 85% equities. "The clients had bought bond funds because they feared they wouldn't have enough income," says Hengehold. "But they had also taken on a lot of interest-rate and inflation risk."
To meet their near-term income needs, Hengehold put $150,000 into a "ladder" of bonds, $30,000 of which will mature in each of the next five years. He then built what he calls a "Noah's ark" portfolio (because it could weather any storm) with Baron Asset, Merger, SoGen International, Mutual Discovery, and Robertson Stephens Contrarian funds, a group of funds that, he says, have a low-risk profile relative to the stock market. "If we went through a bear market, that core would not be off more than 3% or 4%," says Hengehold. He also added five more funds: large-, mid-, and small-cap domestic equity funds, a real estate fund, and an international fund.
Smart asset allocation and fund selection are not just about dampening volatility. If you're comfortable with the level of risk, a portfolio makeover could result in higher returns with no appreciably greater risk. That's what Madeline I. Noveck of Novos Planning Associates Inc. in New York did when she restructured a $650,000 portfolio that included 41% in large-cap U.S. stocks, 32% in U.S. bonds, and 25% cash.
Noveck slashed that large-cap allocation in half and added funds in both growth and value styles and both large- and small-cap. She introduced foreign and emerging-markets equity funds and added several that have low correlations with the U.S. stock market and thus make good diversifiers--natural resources, real estate, and international bond funds. Using the past performance of these asset classes, Noveck estimated that the revised portfolio should generate about a 26% higher return with only a slight increase in volatility.
-- Which funds do you need? Look at which boxes you've filled and which ones are empty. It's not necessary to have a fund in each, but you don't want a lot of duplication, either. An S&P index fund counts as a large-cap blend fund, and if you already own one, you may not need any other large-cap funds. Allocate other money to adding some mid-cap and small-cap funds. In theory, the lower the market cap, the higher the long-term returns--and the short-term volatility.
Growth or value? The two investment styles tend to go through periods when one outshines the other. Younger investors should probably lean toward growth, or look to cover the squares in the lower-right corner, says Jeffrey M. Mortimer, vice-president at Higgins Associates, a Cambridge (Mass.) investment consultant. If you have enough money to spread around, select funds that cover both styles.
The number of funds you choose depends on how much you're investing. Many companies have been raising their minimum initial investment. With $10,000 to invest, you may get only four or five funds--but that's enough to cover, say, the four corners of the style box and an international fund to boot. With more money to invest, you can broaden the portfolio to add such diversifiers as international bonds or real estate, or play a hunch on the comeback of a beaten-up sector.
"I always try to buy low, so I've been buying a little of the Japan Fund each month," says Scott Price, 29, a U.S. Navy engineer from Arlington, Va. "And it keeps getting lower." Price, like many fund investors, practices dollar-cost averaging. He makes monthly investments in each of his 12 funds that together amount to nearly half his take-home pay.
If you have to sell funds in the course of your portfolio's makeover, try to do it within the confines of your tax-deferred retirement accounts. If you're dealing with taxable funds, minimize the tax bite by choosing funds with the highest cost basis so as to minimize capital gains. If the tax bite is going to be large, take more time in restructuring and spread the sales out over several years.
-- Monitor your portfolio. Funds and markets don't stand still, so your portfolio will eventually stray from your game plan if you don't pay attention. Tally your holdings monthly or quarterly to see if you're on track. Remember that the more funds you buy, the greater the claim on your time. Fund enthusiasts like Price and Shellady use computers to keep records, update prices, and keep tabs on their funds and read extensively to keep an eye on what's happening in the markets and in mutual funds.
You can ease some of the record-keeping duties by sticking with one fund family or a fund network operated by one of the large discount brokerage houses. But that can somewhat limit your options. As you monitor your portfolio, you may want to trim some positions that have become too large and add to those that have shrunk. That way, you're taking some profits and reinvesting into cheaper funds.
If a fund's performance has been sagging lately, don't be too quick to sell. The fund still may be beating others in its investment category. When small-cap growth stocks get slammed--as they did in the second half of 1996--few small-cap growth funds looked very smart.
Not every one of your holdings is going to be a winner all the time. By opting for funds of many asset classes and investment styles, you're always going to own a few laggards. But what counts is that together, the funds in your portfolio make beautiful music.