When Your Fund Switches Tracks

A change in strategy can be risky--and what do you do about it?

It's a tempting move for a mutual-fund executive. The bear market annihilates one of your funds, so you replace the portfolio manager or even change the fund's investment strategy, dumping riskier growth stocks for the tamer industrial and consumer issues favored by cautious value managers. That's happening at dozens of U.S. growth funds, which are down an average of nearly 40% from the market peak nearly two years ago.

Such shuffling can sometimes lead to unexpected--and disappointing--results. The changes that might have been savvy 18 months ago could even be counterproductive now after such a serious decline. A reactive shift in investing style may mean that a fund underperforms its peers or its benchmark index when the kinds of stocks it traditionally owned come back into favor.

That was the scenario at numerous value funds a few years back when growth funds ruled the day. For example, the $1 billion Safeco Equity fund--then a large-cap value fund--underperformed the Standard & Poor's 500-stock index for three years straight in the late 1990s. So in late 1999, Safeco management decided to fire up the fund by pumping growth stocks into the mix. But the timing was terrible, as growth stocks peaked a few months later. Value funds gained an average of 6% in 2000, but Safeco Equity dropped 11%. "You can't time when the market is going to flow between growth and value," says veteran growth-fund manager Fred Kobrick, who gave up running mutual funds late last year to concentrate on private accounts.

Unfortunately, investors are often the last to know about changes in investment strategy under way at their funds. Fund companies rarely notify investors in advance of a manager change or a new investment approach. Even when they do, it's not always obvious how to respond. Should you sell the fund or trust that the changes will boost your fund's returns?

Before you make any moves, you need to gain some understanding of the direction of your fund. For instance, fund-watchers are wondering about recent moves at the Vanguard U.S. Growth Fund. After a dismal 2001 and first half of 2002, Vanguard dismissed longtime adviser Lincoln Capital Management and replaced it with Alliance Capital Management, who handed it over to two of its veteran managers, John Blundin and Christopher Taub. When they took over last summer, the pair quickly cut the tech holdings and added stocks such as Tyco International and Citigroup, which have recently been dragged down by investors' concerns over aggressive accounting practices and the fallout from Enron.

So far, the results are mixed. The fund was up 19.8% in the fourth quarter, vs. 14.9% for its peer growth funds. But it dropped 7.9% through Feb. 13, vs. a 3.5% drop for the average growth fund. Vanguard's Jeffrey Molitor, who monitors the company's portfolios, says U.S. Growth remains a true growth fund, and its largest holdings include classic growth names such as General Electric, Microsoft, and Home Depot. Even so, Morningstar analyst Christopher Traulsen suggests investors hold off buying into the fund until the new managers prove themselves.

Some fund watchers also suspect managers of the once high-flying Janus Twenty Fund tilted toward value stocks. That's a charge manager Scott Schoelzel denies. He says he did unload positions in Cisco Systems and Sun Microsystems last year--and underperformed the market when tech stocks rallied in the fourth quarter. "I've made two or three changes in the stocks," says Schoelzel, "but I haven't changed my stripes."

Putnam Investments' growth funds have also undergone some overhauling. The company's equity funds lagged badly behind their peers in 2000 and 2001, ranking 15th out of the 20 largest fund families. In response, Putnam has made a series of manager changes over the past year, including removing Putnam OTC & Emerging Growth manager Steve Kirson in January. Putnam executives ordered the OTC fund's new management team to be less aggressive. The fund still draws its investments from the companies in the Russell 2000 index, but has now widened its scope to take stocks from the 800 fastest-growing companies--the top 40%--in the index. Previously, it concentrated on the top third.

While that's not a dramatic change, Stephen M. Oristaglio, Putnam Investments' deputy head of investments, says Putnam has also imposed new risk controls at all its growth funds. Most important, he says, the firm now requires growth funds to spread their bets over a broader group of industries. For example, several Putnam growth funds recently trimmed their tech holdings and picked up cosmetics maker Estée Lauder, advertiser Interpublic, and scientific-instrument maker Waters. Oristaglio insists his growth funds are not abandoning growth for value stocks. "Some of our competitors are getting more conservative, and while that strategy can look good in the short run, we're confident we'll bounce back," he says, when growth stocks return to favor.

You can hardly blame managers for tweaking their strategies. Funds that don't make changes can wind up in disastrous shape. Exhibit A is Fidelity Investments' $7 billion Aggressive Growth fund, which steadfastly stuck with volatile high-tech and biotech stocks and wound up dropping 75% over the past two years--one of the worst performers among its peers.

When your fund changes course, there's no blanket prescription on what to do. But there are some guidelines:

-- If the portfolio manager has been switched, look at the new leader's track record. The fund company may tell you what funds the manager previously ran, but you may have to find the numbers yourself. That's easy at such Web sites as Morningstar.com or the interactive mutual fund scoreboard at Businessweek.com. Be sure that the new manager of, say, a small-cap growth fund, has invested in small companies before.

-- If the fund has switched strategies, you need to ask if the new approach fits in with your investment plan. If you still want a tech-heavy growth fund, then you may not be satisfied with a fund that's loaded up on consumer stocks. "If asset allocation and investment style are important to you, you may want to get rid of the fund," says Philip Edwards, managing director of Standard & Poor's Investment Services.

You may not have an opinion about a new manager or strategy. You're just interested in results? Keep a close eye on the fund's performance to be sure the changes are paying off.

By Geoffrey Smith

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