Chapter 11. The Devil Is in the Details, and Other Disconnects

Chapter 11. The Devil Is in the Details, and Other Disconnects

In addition to problems with names and classes of shares, investors suffer other mishaps in trying to pick the right fund for them, or determining if they are exposed to more risk than they think.

Much important information about mutual funds is overlooked by investors, both in the aggregate and for individual funds. The devil really is in the details! Many investors do not, and really are not in a position to, pick up these details. To do so requires reading the prospectus and semiannual reports issued by the funds, going to Web sites of sources such as Morningstar, doing some research, and knowing in general what is going on.

Relative to our earlier discussion, reading the popular press articles, with their focus on recent strong performers, can cause you to not focus on information that is of real importance. You must carefully read the details of the prospectus and the semiannual reports, as well as pursue other sources, to ferret out this information.

Most investors understand that return and risk go together; they are, in fact, opposite sides of the same coin. If you want a chance to earn a larger return, you must be willing to take a larger risk. Investors evaluating risk should look at two measures in particular: the beta of the fund and the standard deviation of the returns.

Not all risks are immediately obvious. Derivative securities, improperly used, can add to the risk of a fund. Derivative securities are securities with a value that is derived from an underlying security, such as the common stock of a company. Puts and calls are derivative securities, as the price of a put or a call is directly related to the market price of the common stock involved.

When you buy into a fund and look at the prospectus, you may see that no derivatives are being used. However, a careful reading of the prospectus might tell you that the fund can, at its discretion, use some derivative securities. Thus, down the road the risk of your fund could increase.

New risks in holding mutual funds periodically appear, ones that investors probably never expected or thought of because there was no reasonable basis for doing so. Consider the following example, which would be virtually impossible for many investors to learn about and understand, and even most knowledgeable investors would not realize such an event was occurring.

A significant change has occurred in the banking industry whereby large banks are syndicating loans. The banks, which earn fees for making the loans, are in effect shifting the risk of these loans from themselves to those who take on a portion of the loans made. What is significant about this new trend in commercial lending is that mutual funds have become the largest buyer of new syndicated loans, actually surpassing the banks themselves. Mutual fund shareholders, in turn , are assuming the risk of these loans, and in most cases they probably have no idea that they are doing so.

The scope of this trend is wide in nature, and the risk is not inconsequential. [1] In 2000 banks syndicated some $1.2 trillion in loans, and approximately one fourth of this amount involved loans to noninvestment-grade borrowers.

[1] This information concerning syndicated loans is based on Jathon Sanford, "As Loan Defaults Rise, Banks Shift Some Risk to Individual Investors," The Wall Street Journal , July 23, 2001, pp. A1, A6.

Now consider what can happen. Eaton Vance Prime Rate Reserves is a money market fund that sounds like any other money market fund ”one that invests in high-grade, short- term securities. This fund took a share of a loan to Teligent, a high-flying telecommunications company in the late 1990s. In 2001 Teligent sought bankruptcy protection.

In July 2001, some 67 prime-rate funds specialized in bank loans. These funds held about $160 billion in loans. Based on SEC actions, some of the funds have written down these assets, leading to a reduction in returns. A report in July 2001 indicated that the largest funds had seen returns fall to 2.67 percent over the 12 months ended midyear 2001, versus a five-year average of more than twice that rate.

A Morningstar analyst summarized this situation nicely : "A lot of people were looking at them as something that would never lose principal. That's clearly not the case." [2]

[2] Ibid. p. A6.

Very quickly, funds can change the weightings of various sectors, thereby changing the return and risk characteristics of the fund. This happened to many funds in 1999 and 2000 as they overweighted in technology stocks. When the technology sector took a dive in 2000 and into 2001, the funds suffered significantly. The same thing happened in 2001 with energy stocks.

We all know about the energy "crisis" in the spring of 2001. California's problems made the headlines on a regular basis. Many funds, in response to this situation, loaded up on energy stocks. At the time, the energy sector accounted for less than eight percent of the S&P 500 Composite Index. At least 25 funds not specializing in energy stocks all of a sudden had three times that weighting in energy stocks. This would be a good bet if things work out, but a bad bet if energy stocks don't perform so well.

What if a mutual fund holds securities that are rarely traded and you don't realize it? The results can be disastrous. Consider the Heartland High Yield Municipal Bond Fund, which did exactly that ”held nonrated municipal bonds that were not easily priced. During one day in October 2000, this fund suffered a 70 percent drop in value, probably as a result of trying to sell many of its bonds and finding they were not worth what had been assumed. The SEC obtained a court order freezing the assets of the firm.

Even when mutual fund shareholders have the details, they may not mean as much as they think. Take a look at a fund's top 10 holdings, which mutual funds make available as part of their information set disclosed to investors. Although funds are required only to disclose their entire portfolios twice a year (an SEC regulation), a number of funds disclose their top 10 holdings more often, presumably to let shareholders know more about what the fund is doing. For example, Janus discloses this information six times a year, and Vanguard discloses its top holdings on its Web site monthly.

How valuable is this information? Morningstar decided to examine this issue and find out. Based on a recent five-year period, Morningstar determined that the percentage returns of the top 10 holdings outperformed the overall portfolio for only 48 percent of the funds examined. This, of course, is less than 50 “50, what we could accomplish with a coin toss. The study concluded that while the top 10 positions may indicate a fund manager's style, there was little value to this information otherwise . In fact, the results indicated that a fund manager whose top 10 positions did not do as well as the portfolio as a whole is not necessarily a bad stock picker. [3]

[3] The information in this paragraph is based on Tim Lauricella, "A Mutual Fund's Top Stocks May Mislead," The Wall Street Journal , September 7, 2001, p. C1.

Now consider the "disconnects" that occur between what investors think is going on and what is actually going on. The following examples actually occurred. [4]

[4] These examples and this discussion is based on Jonathan Burton, "Were You Sweet Talked By Your Funds?" Mutual Funds , August 2001, pp. 62 “64.

  1. AIM Charter, listed as a growth and income fund, states in the marketing brochure that as a fund it is a "relatively conservative entry into the stock market." In early 2000, the semiannual report issued by the fund stated that dividend-paying companies would continue to be an important part of the portfolio. By the end of 2000, the number of dividend-paying stocks had been cut by about one third and more than 40 percent of assets were invested in the technology sector.

  2. Strong Growth and Income Fund, according to its literature, can "help to offset the volatility of more aggressive stock funds," and may invest "any amount" in cash "as a temporary defensive position to avoid losses during adverse market conditions." In early 2000, this portfolio was heavily invested in tech stocks and non-blue-chip stocks.

  3. Waddell & Reed Advisors Retirement Shares indicated in its prospectus that its portfolio is geared partly for "capital stability." In fact, the fund held a substantial stake in technology stocks. Shareholders looking at the semiannual report could easily miss this because Cisco was listed under "Industrial Machinery and Equipment" and some Internet-related stocks were listed under "Business Services."

What happened to these funds when the market declined sharply? Between April 2000 and March 2001, the S&P 500 Index declined 21.7 percent:

  • AIM Charter lost 37 percent.

  • Strong Growth & Income lost 32 percent.

  • Waddell & Reed Advisors Retirement Shares lost 29 percent.

This situation is well summarized by Roy Weitz, copublisher of a Web site called FundAlarm.com: "There's a disconnect between what the manager is doing and what the marketing people are selling." [5]

[5] See Burton, "Were You Sweet Talked," p. 64.



Mutual Funds(c) Your Money, Your Choice... Take Control Now and Build Wealth Wisely 2002
Mutual Funds(c) Your Money, Your Choice... Take Control Now and Build Wealth Wisely 2002
ISBN: N/A
EAN: N/A
Year: 2004
Pages: 94

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