Highlights and Commentary

By Roy Weitz

(Originally posted April 1, 2002) [Archive Table of Contents]
How low can you go? Even if you don't follow mutual funds closely, you probably know that the Japanese stock market has been a basket case for at least 10 years, and mutual funds that invest in Japanese stocks have suffered along with the Japanese market.....What may surprise you, however, is that 68 funds in this month's FundAlarm database have actually performed worse than the average Japan mutual fund over the past three and five years.....A number of international funds are included in this "how-low-can-you-go" group, but the group also contains funds from every benchmark category other than balanced.....You probably won't be surprised to learn that the vast majority of these funds are 3-ALARM, and many of them make a regular appearance on our list of "Most Alarming 3-ALARM Funds."

And you thought Japan funds were bad? See the accompanying page for funds that have performed worse than the average Japan fund over the past three and five years

Every audit of a mutual fund culminates in an auditors' report, and you could read a hundred audit reports without finding five words that were different.....In other words, the auditors' report is typically a boilerplate blessing of a mutual fund's financial statements, and nobody pays much attention unless the report contains something unusual.....Well, people are definitely paying attention to the 2001 audit report of the Van Wagoner funds, which was recently issued by the Ernst & Young accounting firm.....Actually, it's a document that was issued in conjunction with the Ernst & Young audit report -- an internal control letter -- which has raised so many eyebrows.....Ordinarily, an auditor's internal control (IC) letter is as boring as an auditors' report, but the Van Wagoner IC letter contains some pretty hot stuff.....Basically, Ernst & Young found that the Van Wagoner funds suffered at least two serious breakdowns in its internal accounting and administrative controls during 2001: (1) The Board of Directors didn't properly document the valuation (i.e., pricing) of the funds' private placement investments, and (2) The funds violated their own non-fundamental investment restriction when they allowed private placement securities to exceed 15% of fund net asset values.....(Private placement securities, which do not have published market values, are typically available only to sophisticated investors).....Both of these problems were compounded by the fact that the Van Wagoner "Board of Directors" was made up of only two people: Garrett Van Wagoner himself, and one outside director.....A third director resigned in July 2000, but Van Wagoner didn't bother replacing him until February 2002,* and then almost certainly because Ernst & Young was breathing down his neck.....The Ernst & Young findings don't mean that Van Wagoner is a crook.....But the IC letter does show that Van Wagoner is a sloppy and undisciplined administrator, and it's reasonable to assume that these traits also carry over to the investment side......Several months ago, we referred to the Van Wagoner funds as a "cowboy" operation, and at least one reader took strong exception to our choice of words.....Dear Reader: This is exactly what we meant.....Van Wagoner appears to lack the resources and temperament needed to run a public mutual fund.....Caveat investor.
* Van Wagoner's Valuation Policy Is Criticized by Firm's Auditors," Tom Lauricella, The Wall Street Journal, March 4, 2002


The release of the Ernst & Young internal control letter, above, comes on the heels of several lawsuits alleging that the Van Wagoner funds failed to properly review and mark down the value of their private placement securities, thereby overstating the net asset value of those funds and overcharging new investors.....Will the Ernst & Young letter be used as evidence against Van Wagoner in these lawsuits?.....A Van Wagoner representative claimed that the internal control letter was no big deal, while several plaintiff's lawyers were too excited to say anything at all.


And speaking of private placements: In anticipation of the next bull market for technology stocks, the Amerindo funds have decided to add private placement securities to their investment portfolios.....Investors had little reaction to the move, but class-action lawyers gave the decision a big thumbs-up.


Here are the "search" instructions from the John Hancock Web site. Can you guess how long it's been since someone last revised them?



Morningstar has announced a new rating service for private-account money managers, and that could be good news for mutual fund investors..... Why should fund investors care?.....Mutual fund managers often come from the world of private accounts, and currently there's no easy and reliable way for investors to evaluate a money manager's private-account track record.....Experienced private-account managers, just starting out in the mutual fund world, are often overlooked or avoided.....But in many cases, these are exactly the kind of managers that mutual fund investors should be looking for.... If Morningstar is successful with its new private account ratings, fund investors should have a much easier time spotting fresh talent, and that's good news for anyone who likes to make money.


In case you think this talk about private money managers, above, is purely theoretical, here's a real-life example.....A couple of months ago, the Berger funds acquired a small San Francisco money management firm run by Bill Schaff, and Schaff's firm was almost immediately named as subadvisor for the new Berger Large Cap Value fund.....Roy happens to be familiar with Schaff's excellent record as a private large-cap money manager, so Berger's new fund immediately caught Roy's eye......Mutual fund columnist Tim Middleton, who doesn't know Schaff up-close, recently advised his readers to avoid Schaff until he proves himself*.....We think this is bad advice, but we understand exactly how it happened: Middleton has no information about Schaff's private record, while we do.....If Morningstar's private-account rating service were already up and running, Middleton would have had access to the same information that we do, and he probably would have called this one correctly.....In the meantime, we plan to watch Schaff's new fund very closely.....If you're looking for a good large-cap value fund, you might want to do the same.
* "Let fund managers learn on someone else's dime," moneycentral.msn.com, March 6, 2002


Imagine how smug he'd look if his funds didn't suck:

Malcolm R. Fobes III, as he appears on the Berkshire Funds Web site	Malcolm Fobes is the manager of Berkshire Focus and Berkshire Technology.....For the 12 months ended February 28, 2002, these funds lost 58.82% and 58.50%, respectively.....Only ten funds in the U.S. performed worse over the same period of time.

The perils of chasing hot funds (installment #97 in a continuing series): Nicholas Applegate Global Technology was the hottest fund in the U.S. during the overheated year of 1999, returning 493.7%.....During that same year, value funds generally didn't perform well, and Sequoia was the worst-performing value fund of all, returning -16.5% for the year.....On January 1, 2000, let's assume that a frustrated investor moved $100,000 from stone-cold Sequoia to red-hot Nicholas Applegate Global Technology.....Twenty-six months later, on February 28, 2002, that $100,000 would have shrunk to $28,300.....If our hypothetical investor had simply left the money with Sequoia, that $100,000 would have grown to $130,200.....You might want to think about this difference in value -- almost $102,000 -- next time you're tempted to chase a hot fund.


Seligman Growth A (SGRFX) celebrates its 65th birthday this month, but it's far from being the oldest mutual fund in the U.S......In fact, thirty-four stock and balanced funds are older, including the granddaddy of them all, MFS Massachusetts Investors Trust A (MITTX), which will turn 78 in July.....Since Roy has already received an invitation to join AARP, he is no longer allowed to make Metamucil and Viagra jokes.....But the question remains: How well are these senior citizen funds performing? Does age truly beget experience, or is it time for these funds to hang up their ticker symbols?.....Here's the entire list:

Funds are sorted alphabetically; funds in green
have outperformed the Vanguard 500 Index over the past 15 years

Geezer Fund	Inception	15-Yr. Return (% annlzd)
Alliance Balanced Shares A (CABNX)	1932	9.16
Alliance Growth & Income A (CABDX)	1932	12.14
American Funds American Balanced A (ABALX)	1933	11.14
American Funds Fundamental A (ANCFX)	1933	12.28
American Funds Inv Company of America A (AIVSX)	1934	12.4
Benchmark: Vanguard 500 Index (VFINX)		12.1
CDC Nvest Growth and Inc A (NEFOX)	1931	9.6
Century Shares (CENSX)	1928	12.39
CGM Mutual (LOMMX)	1929	8.85
Dodge & Cox Balanced (DODBX)	1931	12.25
Eaton Vance Balanced A (EVIFX)	1932	8.55
Eaton Vance Growth & Inc A (EHSTX)	1931	11.79
Elfun Trusts (ELFNX)	1935	13.48
Evergreen Balanced B (EKBBX)	1936	8.27
Evergreen Blue Chip B (EKNBX)	1935	8.67
Evergreen Large Co Growth B (EKJBX)	1935	9.31
Evergreen Small Co Growth B (EKABX)	1936	8.47
Federated Stock & Bond A (FSTBX)	1934	8.58
Fidelity (FFIDX)	1930	11.83
Franklin Growth & Income A (FKREX)	1933	9.64
Gartmore Total Return D (MUIFX)	1933	11.3
Hancock Sovereign Investor A (SOVIX)	1936	10.04
ING Corporate Leaders (LEXCX)	1935	11.41
INVESCO Growth Inv (FLRFX)	1935	5.38
Lord Abbett Affiliated A (LAFFX)	1934	11.89
MFS Massachusetts Inv A (MITTX)	1924	11.34
MFS Massachusetts Inv Growth A (MIGFX)	1935	12.47
Pioneer A (PIODX)	1928	11.67
Putnam Investors A (PINVX)	1925	10.11
Safeco Equity (SAFQX)	1932	11.42
Selected American (SLASX)	1933	12.91
Seligman Common Stock A (SCSFX)	1929	7.68
Seligman Growth A (SGRFX)	1937	8.69
Sentinel Common Stock A (SENCX)	1934	10.34
State St Research Investment S (STSTX)	1924	10.14
Vanguard Wellington (VWELX)	1929	11.17

It's interesting to note that Dodge & Cox Balanced, a mix of stocks and bonds, slightly outperformed the all-stock Vanguard 500 Index over the past 15 years, the longest period for which we have data.....On the other hand, several all-stock funds -- CGM Mutual, Evergreen Blue Chip, Evergreen Large Company Growth, Invesco Growth, Seligman Common Stock, and Seligman Growth A -- trailed the Vanguard 500 Index by 300 to 400 basis points (3.0% to 4.0%).....Overall, on the upside, only eight of our thirty-five geezer funds were able to outperform the Vanguard 500 Index, and even the best fund in the group, the Elfun Trusts, beat the 500 Index by only 138 basis points (1.38%).....Perhaps if we had performance data from inception, one of these old-timer funds would be a true standout, but we doubt it.....A list like this confirms one of the immutable facts of mutual fund investing: Whether your fund was born in 1924 or 1994, it's extremely tough to beat an unmanaged index over a long period of time.


Briefly noted:

• If you need proof that the mutual fund job market is tight, consider this: The struggling and oft-reinvented Lindner funds, now down to about $500 million in assets, have managed to hire three executives who actually some professional credentials.....On second thought, it's pretty clear to us that this is a Hail Mary deal for the new guys, who will serve as chief operating officer, chief investment advisor, and chief administration officer.....The new execs have almost certainly negotiated some substantial equity incentives in the Lindner management company.....If they make this long-shot work, they get rich.....If not, they leave behind the shriveled corpse of an already-dead mutual fund company.....Hey, what the heck: Any shareholder who has stuck with Lindner this long isn't going to complain about another failed scheme.
  
  
  
• Ned Johnson is the quiet, low-profile billionaire who runs the Fidelity fund family, but it appears that even Johnson can get riled by a home contractor......Over four days last month, in a Maine courtroom, Johnson duked it out with a contractor who also happened to be Johnson's friend and tennis buddy for the past 30 years.....At stake was 0.00116% of Johnson's net worth ($50,000), which the contractor claimed was his fee for supervising construction of Johnson's home workshop, and which Johnson insisted he didn't owe.....According to the lawsuit, the contractor began overseeing construction of the workshop in November 1999, but the financial arrangements were never put down in writing....."Trust the Great Oracle," Johnson reportedly assured his friend......Johnson is also known as a modest man, which is probably why he didn't refer to himself as God.
  "The 'Oracle' wins again," Steve Bailey, boston.com, March 8, 2002
  
  
  
• Just to put Johnson's lawsuit in perspective: If you were worth $1 million, and someone sued you for $11.60, you'd have the same percentage of your net worth at risk as Johnson had during his four-day trial, above.....Seems like an insignificant amount to fight about with a 30-year friend, so it must have been the principle of the matter that made it all worthwhile.
  
  
  
• Trent May was recently fired as manager of the abysmal Invesco Growth fund, but May is apparently still good enough to manage Invesco Endeavor.....If you own Invesco Endeavor, and you're a compassionate person, you might feel good about providing Mr. May with a place to work.....On the other hand, if your goal is to make a decent return on your investment, you might want a manager who isn't someone else's reject.
  
  
  
• Doug McEldowney, co-manager of Invesco Growth, was fired along with Trent May (above).....McEldowney's booby prize is Invesco Global Growth, which he continues to manage.
  
  
  
• Here's an astonishing statistic: Last year, 71% of U.S. equity fund managers had a compensation package based on investment performance.....No, it's not that so many managers have a compensation-based package, it's that almost 30% of fund managers have no financial incentive to outperform either their benchmark or their peer group.
  "More Mutual Funds Are Basing Managers' Pay on Performance," Yuka Hayashi, Dow Jones Newswires, March 15, 2002
  
  
  
• What does a manager's compensation package look like when it is based on performance?.....At the John Hancock funds, manager's pay has been based almost entirely on performance since 2000.....Hancock uses a blended formula that relies on a manager's performance versus his or her peer group: 70% of the weighting goes to three-year performance, and 30% goes to one-year performance.....According to Hancock, this kind of pay scale can create a big gap between performers and non-performers.....For example, a manager whose performance falls below the peer-group median for both one- and three-year periods could receive no bonus, while a manager within the top 20% for both periods could receive a bonus worth up to three times base salary.
  Source: Yuka Hayashi article, above
  
  
  
• Speaking of financial incentives, there's a new fund with an interesting fee structure.....Quintara Small Cap Value will be managed (technically, sub-advised) by three experienced, hired guns: Curtis Jensen of the Third Avenue funds, Warren Isabelle of the ICM/Isabelle funds, and James Benson and Clyde McGregor of the Oakmark funds.....Each manager initially will be given one-third of the fund's assets, as well as one-third of all inflows, and each one-third portfolio will be limited to a maximum of 18 holdings (about 55 in total).....Each manager will receive a "base" management fee of 1.075%, plus or minus 0.075%, depending on his performance relative to the fund's benchmark (the Russell 2000 Value Index).....If the SEC approves, the Quintara fee structure will get even more creative: The base management fee will rise to 1.15%, but each manager will be required to contribute 0.15% of each fee payment to the fund's "incentive compensation pool".....If all three managers outperform the benchmark for the year, 60% of the incentive pool will be awarded to the manager with the best record, 30% to the manager with the next-best record, and 10% to the manager with the worst (but still benchmark-beating) record.....If only one of the managers beats the benchmark, 60% of the pool will be awarded, and the rest will carry over.....If none of the managers tops the benchmark, none of the pool will be awarded, and all of it will carry over.....Obviously, none of these managers will go hungry if he doesn't earn a performance fee, or if he doesn't participate in the incentive pool.....The problem with many performance-fee structures, like this one, is that the base fee is set too high, and the performance reward (or penalty) is almost insignificant for an established manager.....Still, fund managers are a competitive bunch, and the incentive pool, in particular, could get some of their competitive juices flowing, with good results for investors.....Right now, the fund is operating with the basic performance fee structure, while the SEC figures out what to do about the incentive pool.....We'll let you know when, or if, the SEC decides in favor of the incentive structure.
  
  
  
• It must be something in the cheese: Frontier Equity, based in Pewaukee, Wisconsin, is a tiny mutual fund with a big distinction: At 15.6%, it has the highest expense ratio of any fund in the U.S......Frontier Equity is managed by Jim Fay, who also runs a financial planning firm in the Pewaukee area, and most of the fund's 110 shareholders are Fay clients.....The fund's directors have tried several times to kill the fund -- as they should -- but each time fund investors have rallied to keep the fund open.....Not surprisingly, fund performance has been abysmal, with a five-year annualized return of -24.33%.....And you know what?.....Fund investors don't seem to care.
  "Nation's priciest fund lives off local support," James Paton, Reuters, March 1, 2002
  
  

  Update (April 5): A FundAlarm reader reminds us that the 15.6% expense ratio, above, was for the fund's fiscal year ended September 30, 2000. For the most recent fiscal year-end (September 30, 2001), the fund's expense ratio reached the almost confiscatory level of 32%.

  
  
  
• WM Growth Fund of the Northwest is now allowed to invest in California companies, so it has changed its name to WM West Coast Equity Fund.....Anticipating future eastward expansion, fund executives have reportedly reserved still another new name, the WM Up-to-the-Mississippi-River Fund.....Growth Fund of the Northwest was a quirky little fund that somehow managed to generate an exceptional long-term record investing in companies based in Washington, Oregon, Idaho, Montana, and Alaska.....Of necessity, the fund had a strong small-cap flavor, which is now likely to be altered by its California holdings.....The fund also experienced a recent manager change, with Philip Foreman replacing Randall Yoakum, who himself replaced David Simpson less than a year ago.....The expansion to California and the manager turnover make this essentially a new fund.....For better or worse, that remains to be seen.
  
  
  
• On a single day in October 2000, two Heartland muni bond funds lost 70% and 44% of their value after several defaulted and illiquid securities were suddenly revalued.....This kind of thing isn't supposed to happen to muni bond funds, and it isn't supposed to happen if fund managers and directors are doing their job, so the lawsuits started flying fast and furious.....Now, the legal action is winding down, and it looks like the folks at Heartland may escape with barely a slap on the wrist.....Overall, investor losses were estimated at about $87 million.....According to the terms of a proposed settlement, Heartland will pay investors $14 million, but only $4 million will actually come out of Heartland's pocket.....The remaining $10 million will be covered by Heartland's insurance company (a smaller amount also has been recovered through various sales of distressed securities).....Talk about sending mutual fund companies the wrong message......Here's one of the most flagrant cases of mutual fund mismanagement in history, which caused huge pain for thousands of investors, and the perpetrator of this fiasco gets off with a $4 million flea bite.....We recognize that this is civil litigation, and civil lawsuits usually don't punish wrongdoers.....But if $4 million is the full extent of Heartland's discomfort, and the firm isn't also hit with punitive damages or a significant SEC fine, then Heartland will have gotten away essentially scot-free.....How about O.J. for the next Board vacancy?
  Reuters, March 25, 2002
  
  
  
• U.S. Global Leaders Growth is one of those small, virtually unknown funds that regularly outperforms its much larger and better-known rivals.....If you discovered this fund on your own, and you've owned it for a while, congratulations -- you've got a little gem.....But, before you party too hard, here's the bad news: John Hancock just bought your fund, they're turning it into a load offering, and you can expect asset bloat to hit any day now.....Managers George Yeager and George Fraise have signed three-year contracts to continue running this offering under Hancock but, even so, this fund is now little more than a sideline for them.
  
  
  
• Vanguard has also been out shopping......If current shareholders approve, Provident Investment Counsel Mid-Cap will become Vanguard Mid-Cap Growth, and Schroder International Smaller Companies will become Vanguard International Explorer.....Both actively-managed funds fill gaps in Vanguard's lineup, and both have decent multi-year records, but these acquisitions further confuse Vanguard's marketing message -- are index funds the right way to go, or not?.....Many newspapers now list Vanguard index funds separately from Vanguard's actively-managed funds.....Maybe it's time for Vanguard to split into two separate companies -- Active Vanguard and Indexed Vanguard-- and let the two companies compete against each other.....Vanguard index funds might become even cheaper, since they wouldn't have to support the staff that oversees the actively-managed funds.
  
  
  
• And here's still another confusing message: Vanguard has reportedly been trying to market its own hedge-fund to high-net worth customers .....So far, investor response has been underwhelming, which isn't surprising, since Vanguard doesn't immediately come to mind as a purveyor of cutting-edge financial strategies.....There's also the little problem of John Bogle, Vanguard founder, who has been preaching the futility of active management for at least 30 years.....But perhaps Bogle just isn't smart enough.....According to a Vanguard marketing brochure for the new hedge fund, "...outperforming public benchmarks over the long term is dependent on manager selection."
  "House that Jack built boasts a new gospel," David Hoffman, Investment News, March 25, 2002
  
  
  
• Back in January, Colin Ferenbach suddenly left as manager of the Haven Fund, which he had run since its inception in June 1984.....Ferenbach was also a founder of Haven Capital Management, the company that held the investment contract for the Haven Fund, so clearly there was some kind of falling-out between Ferenbach and his partners.....Ferenbach subsequently landed at Tocqueville Asset Management, and now it looks like he's going to be running the Haven Fund again.....In late February, the trustees of the Haven Fund voted to terminate the investment contract with Haven Capital Management, and enter into a new contract with Tocqueville, with Ferenbach as day-to-day manager.....If the Haven trustees truly feel that Tocqueville/Ferenbach can run the fund better than the folks at Haven, then the trustees have done exactly what they're supposed to do, which is protect the interests of the Haven Fund shareholders......But please excuse us if we suggest that this whole thing looks like a set-up .....We'll bet that Ferenbach knew exactly what the trustees were going to do, before he cut his ties with Haven.
  
  
  
• See, it can be done: Wasatch Core Growth and Wasatch Core Value have been closed to new shareholders for some time.....Wasatch has just closed these funds to existing shareholders as well -- a tough move, and one that deserves a lot of credit.
  
  
  
• If you've been reading FundAlarm for a while, you know that the extremely dumb IPS iFund has been under a death watch almost since its inception, in December 2000.....Well, the fund is still alive, but just barely.....As of November 30, 2001, the latest available date, the IPS iFund had $95,029 in net assets, up from $64,931 as of May 31, and the fund had generated $753 in management fees for IPS during its eleven-month existence.....We don't think anyone from the IPS iFund entered the FundAlarm death watch contest, but maybe they should have.....The $100 prize would boost the fund's annual income by 13%.
  
  
  
• If nobody wants to buy their mutual funds, at least they'll be able to butter a roll: Etiquette training is reportedly becoming a popular perk for mutual fund salespeople.....For about $100 per person, representatives from such companies as Scudder, Evergreen, and Van Kampen are enrolling in seminars to learn table manners, introductions, and other social niceties.
  "Charm School for Mutual Funds," Mara Der Hovanessian, Business Week, April 1, 2002
  
  
  
• Back in February, American Express stole four top fund managers away from Fidelity, and now it's Fidelity's turn to retaliate......Fidelity has announced that it will no longer use American Express for its employees' travel services and corporate charge cards

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