Mutual Funds: The Worst May Not Be Over

With funds hit hard, it's time to fine-tune--not bail out

Mutual-fund investors have taken their knocks lately. The speculative excesses and lure of high-flying tech and growth stocks are behind them, but their toughest test of wills may still lie ahead. The new hurdles: an accelerated decay in corporate earnings, an economy slumping towards recession, and new global political tensions roiling the financial markets. So far, investors have chosen the path of least resistance: "It's a Zen thing," says Daniel G. Bandi, co-manager of the $700 million Armada Small Cap Value Fund, who saw his heady 11% gain through August turn into a 4.2% decline by Sept. 24. "You just have to go along for the ride."

While no one is urging investors to panic and liquidate their stock and mutual-fund holdings, the time for crisis-proofing investments has come. Most investors still hold far too many richly priced securities--even after a bear market that began in the spring of 2000. And like professional money managers, they should consider lightening up their stock funds in favor of bond funds and maybe buy a "bear" fund to hedge risk, beef up on dividend-paying securities, and--in the words of billionaire investor Warren E. Buffett--never forget that the dumbest reason to buy a stock or mutual fund is because it's going up.

Perhaps the most disheartening prospect is that there's no sense that values will stop falling. Frederick B. Taylor, chief investment officer at U.S. Trust Corp., believes that recent events won't impose a lasting drag on the markets. "[That] doesn't mean that the worst is over or behind us, or that we've necessarily seen the lows," he says. "We're going back to where investors must understand the risk-and-return relationship."

Investors will get a sharp reminder of that lesson when quarterly fund and 401(k) statements begin to arrive in the mail. The damage to mutual-fund portfolios during the third quarter is extensive: The average U.S. diversified fund shed 19.6% through Sept. 24 (table), the worst quarterly performance since 1987. Only one category of fund, precious metals, is in the plus column: up a scant 0.67% after being a losing proposition for most of a decade. Real estate and international hybrid funds are the only two groups that managed mere single-digit losses. Value and growth funds--whether large- , mid-, or small-cap--have lost from 14.4% to 28.5% in the past three months. That compares with a 18% drop in the Standard & Poor's 500-stock index. International stock funds are down about as much as domestic ones, while emerging-markets funds, perhaps the riskiest of the bunch, lost 22.7%, about the same as the developed country funds.

Year-to-date losses for the average U.S. diversified equity fund have now ballooned to 25%, compared with a 1.3% loss for all of last year. Even value funds--whose staunchly conservative managers buy undervalued stocks--didn't resist the trend: The small-cap variety, up a nifty 9.5% in the second quarter, fell 18.5% in the third.

For many investors, these results mean that their long-term investment horizon just got a lot longer. Says John J. Brennan, president of Vanguard Group Inc. in Malvern, Pa: "We're going through wrenching change, but you should have had a perspective longer than a day or quarter," he says. The stock market, is purging the excesses built up during the long bull market. Once they're gone, he says, "you can be bullish for the next 10 years."

That doesn't mean investors can expect a return to triple-digit gains, reminiscent of bubble-happy days of old. Nowadays those are the domain of bear-market funds that bet on falling stock prices. Nearly half the 50 top-performing equity funds use hedging strategies, such as selling stocks short. But even managers of such funds are circumspect about tooting their horns: "We are not marketing these funds for the doomsayers as much as we are to hedge risk," says Charles J. Tennes, portfolio director at Rydex Funds. "To make use of short funds, you combine them with other long-term funds and moderate your exposure; you don't just play the direction of the market."

NO RUSH. Waiting out downturns has paid off for the past 20 years--as markets have always rebounded. And, so far, there's no evidence of widespread defections from funds. Robert Adler of AMG Data Services, an Arcata (Calif.) firm that tracks fund flows, calculates that $5.9 billion left equity funds in the six business days ended Sept. 19--that is, the three days before the terrorists struck and the three days after the market reopened. That amounts to less than 0.5% of all equity mutual-fund assets. Adler says the last time there was a comparable outflow was mid-March, when investors yanked $6 billion from stock funds. "I was impressed that net cash redemptions weren't larger," he says, adding that some bond funds and money-market funds had record inflows. That's partly because financial planners and mutual-fund complexes have been preaching the stand-pat axiom. Robert H. Moody of Compass Advisors LLC in Atlanta has tweaked his clients' portfolios toward short-term bond funds, as well as value and small-cap funds. An investment plan "does not change with current events," he says.

Wholesale dumping of stocks is rarely prudent. But jittery investors who have sold opened up new doors for professional investors previously waiting in the wings. Consider the deep-value Aegis Value Fund (AVALX ), which buys only stocks with single-digit price-earnings ratios. The fund is up 26% this year and has been rushed by a surge of performance-hungry investors--who pushed assets to $23 million from $6 million in June. But co-manager Scott Barbee didn't cut his 40% cash position by half until September. (The average U.S. fund manager has a 5.9% cash stake, up from 5.2% this time last year, reports Morningstar Inc.) "We weren't in a big hurry to buy stocks before because small-cap managers had aggressively bid up prices," he says. "But I feel more positive now about overall valuations than I have in many months." One stock he scooped up prior to the World Trade Center catastrophe was Allied Research Corp. Although the company happens to make mortar shells, it also carries $20 million in cash on its balance sheet, boasts no debt, and sold at just eight times earnings. No surprise, the stock subsequently doubled. Allied, at 5% of the fund, is now Barbee's biggest position.

SOLID NICHES. Robert A. Olstein, portfolio manager of the $500 million Financial Alert Fund (OFALX ), has socked away 20% of his fund's assets in cash since 1999. He's now left with only 4% cash after a spree of buying brokerage stocks--Merrill Lynch, Goldman Sachs, and Morgan Stanley--which he expects to rebound in the coming year. While financial-sector mutual funds have slid 15.5% in the third quarter, neither the intrinsic values of financial companies nor the demographics of their aging baby-boomer customers have changed. Olstein expects that once the "doom-and-gloom of the mood has passed," investors will regain faith in the U.S. markets: "Where else are they going to put their money?" Even battered airline and insurance stocks surfaced as prime buy candidates for some managers. In the past few weeks, Nicholas D. Gerber of Ameristock Focused Value Fund has boosted his position in Midwest Express Airlines from 5% to 15% of the fund and has doubled his holding in KLM Royal Dutch Airlines to 10%.

Some fund managers have shown almost clairvoyant prowess in picking stocks. Just look at David A. Corbin of Fort Worth. The top four long-term holdings in his Corbin Small-Cap Value Fund (CORBX ) have eerily benefited since the Sept. 11 attacks, even though they are years old. The fund's top position is Titan Corp., an electronic-defense company that builds surveillance equipment. No. 2 is Forgent (FORG ), a videoconferencing company, poised to get a lift from travel-wary executives, while No. 3, medical-device maker Cyberonics Inc. (CYBX ), is exploring treatments for psychiatric disorders, such as depression. The fund's fourth-largest stake is in Thomas Nelson Inc., the largest Bible publisher. "We have a number of niche businesses that are benefitting from the chaos, but clearly we didn't know this was going to happen," says Corbin. "We bought these companies because they have very solid fundamentals."

"RUDE AWAKENING." The quarter's biggest losses, no surprise, have been sustained by tech and telecom funds. Kevin Landis, fund manager of the Firsthand Technology Leaders Fund, has lost 38.5% this quarter, but he says most of his investors are staying put: "It's a little late to sell at the top, so the best alternative is to stick it out," he says. Others disagree. Says Peter B. Doyle of Kinetics Asset Management, "The typical investor who is still looking to Dell, Cisco, and Intel as good investments is in for a rude awakening. The valuations are still high."

Some managers are even more wary. Charles Minter's Comstock Strategy, an international hybrid fund he runs for Gabelli Funds Inc., hasn't owned a single U.S. stock since 1997. The fund is up 19.2% year to date, after losing money in the last five years of the bull market. "Our bearishness has nothing to do with terrorist attacks," says Minter. Looking back to the 1974 market bottom when the S&P 500 index sold at eight times earnings, vs. 22 today, he forecasts that the index could fall another 25%. "We can't possibly be giving advice to stay put and don't worry about it," he says. "When you have a bubble like the one you just had, you're more than likely not going to stop at normal valuations. You're going to the trough." On an upbeat note: Minter is formulating a buy list, though he's not made a move yet.

Size has offered some protection. Only two of the 10 largest equity funds had lost more than the S&P this year through Sept. 24, though there were still losses in the double-digits. "I think that people have to understand that these losses do occur," says Daniel P. Wiener, publisher of Independent Advisor, a newsletter that tracks the Vanguard funds. "If the managers are consistent they will come back, but you have to stick with it."

Staying the course isn't necessarily bad advice. But in these uncertain times it will take nerves of steel.

Corrections and Clarifications Owing to problems with Standard & Poor's mutual-fund database, some tables in ``The worst may not be over'' (Finance, Oct. 8) gave incorrect data for merged Firststar funds. Third-quarter returns through Sept. 24 were: First American Equity Index Fund, -17.80%; First American Balanced Fund, -11.82%; First American Fixed Income Fund, +3.86%; First American Tax Free Fund, +2.27%; and First American Small Cap Index Fund, -18.83%.

By Mara Der Hovanesian in New York

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