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A reader's comments on Merrill Lynch Growth,
reproduced with permission

March 15, 1999

A case study in how not to treat mutual fund investors
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On Thursday morning, March 11, I was pleased to read that energy related stocks had surged on news of an impending deal by OPEC to cut production. This was just the sort of news I have been waiting for since the start of the Asia crisis in late '97. One of the victims of the crisis was a mutual fund I own, Merrill Lynch Growth fund, which, under the management of Stephen Johnes and Arthur Moretti, had built up a huge position in energy stocks during 1996. The effect of the Asia crisis was to drastically reduce overseas demand for oil, leading to a large supply/demand imbalance. As a consequence, Merrill Lynch Growth fund began a swift descent, eventually landing at the absolute bottom of performance ratings of domestic growth funds. It was a sad situation for a fund that had earned stellar gains, and the highest Morningstar ratings, throughout the '90's.

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Despite this catastrophic fall, I held on to the fund. I know that investors often hold on to a dog for too long, rationalizing it by saying that they don't want to sell low, but I thought the reasons for holding on to this dog were compelling. Very few people believed that the current situation with oil prices could be sustained forever. It wasn't a question of whether oil prices would recover, but rather when. I felt that sooner or later the oil producing nations would be forced to cooperate to reduce supply, and that demand in Asia would eventually rise.

It is one thing to hang on to a stock like K-Tel, hoping for a recovery. It is another matter altogether to hold on to an offshore oil service company like Global Marine. Johnes argued vigorously that oil field services had entered a period of favorable supply/demand characteristics, following a decade-long shakeout that had significantly reduced capacity in the industry. Any fool can announce that their company is now an "Internet" company; not many people can set up an oil field services company. As such, it would be very difficult to ramp up capacity in this industry when demand grew. Johnes had made a compelling case that these stocks remained an outstanding long term secular bet. He had been right many times before.

Imagine my surprise that morning to see that Merrill Lynch Growth fund had increased in value by exactly zero the day before. It didn't make sense. So I dug up the most recent information I had on the fund's holdings. Checking the stock listings, I noticed that Global Marine was up over 10%, as was Apache Corp. Burlington Resources was up 6%. These three stocks alone accounted for over 15% of the portfolio as of the October 31, 1998 Annual Report. With nearly half of fund assets in energy stocks, and the remainder divided between REITs and cash, which had hardly moved at all, I thought that the fund value should have increased by at least 3%.

I suddenly had a thought that gave me a sick feeling in my gut. I was aware that Merrill Lynch Asset Management, under considerable pressure from brokers and investors, and reeling from bad press, had fired Arthur Moretti six weeks ago. The relatively young and inexperienced Moretti had taken over the fund in March, 1998, upon the death of his mentor Stephen Johnes. Moretti was replaced by Stephen Silverman, who, like Johnes, was a seasoned fund manager with a long record of success. I thought to myself "could Silverman have gutted the portfolio of energy issues just before these stocks make a big comeback?" It seemed the only possible explanation for the surprising lack of movement in the fund, on a day when energy stocks surged in value (fund performance relative to energy stock prices in the following days has removed any doubts I might have had about this explanation).

Later that day, I headed on to the Internet to look for more information. By what seems an amazing coincidence, CNNfn Online had posted an article just a few hours earlier. The article, titled "Merrill fund gets an Rx", was rather disturbing for a number of reasons.

The second paragraph of the article stated:

"Manager Arthur Moretti loaded up on energy and financial stocks, and the fund plunged 24.23 percent in 1998 while competitors soared an average of 18 percent, according to Morningstar, a Chicago fund tracker."

The ninth and tenth paragraphs stated:

"Moretti took the helm in March 1998 and things turned sour."

"Moretti lightened up on technology to 3.5 percent, and put 47 percent of the portfolio into energy and 25 percent in financial stocks, including real estate investment trusts (REITs), said Kunal Kapoor, an analyst at Morningstar. The bet proved disastrous: Energy stocks, for example, lost 30 to 40 percent in 1998."

Morningstar's own mutual fund reports contradict these claims (Mr. Kapoor's words notwithstanding), as do fund reports issued by Merrill Lynch Asset Management. According to Morningstar, as of July 31, 1997, Johnes had already committed 47 percent of total fund assets to energy, and 19 percent to financials. Indeed, Johnes had done so all the way back in 1996, long before his death, according to the report.

Ironically, rather than becoming "loaded up" on energy stocks, by April 30, 1998, shortly after Moretti assumed control of the fund, energy stocks had been pared slightly to 41 percent, and financials were barely up, to 22 percent, according to Morningstar. A stock by stock comparison shows that the fund's holdings barely changed from July 31, 1997 to October 31, 1998. It was Stephen Johnes' portfolio that whole time.

Furthermore, "things turned sour" long before Moretti assumed the helm in March of 1998. Whereas the fund was up over 35 percent in early October, 1997, it finished the year up only 17 percent, putting it near the bottom of the domestic growth fund rankings. During that time Johnes reiterated his investment strategy, reassuring investors that he believed his sector choices would outperform the market over the three to five year investment horizon used by the fund.

You might ask: "does it really matter who was the manager, or what were the circumstances and timing of catastrophic loss of billions dollars in this fund?" In fact, it matters a great deal. Here is why:

Stephen Johnes was a proven star at fund management. Throughout its existence, entirely under the tenure of Johnes, Merrill Lynch Growth Fund consistently garnered some of the highest returns, and some of the highest Morninstar ratings, of any mutual fund. Johnes was a darling of the financial press, repeatedly interviewed about his success. Merrill Lynch Asset Management gladly distributed reports detailing the success of the fund, and articles lauding the stock picking ability of Johnes.

That Johnes made a huge sector bet which resulted in huge losses proved to be an embarrassment to both Merrill Lynch Asset Management, and, I suspect, Morningstar. Indeed, Morningstar awarded the fund five stars, its highest rating, in its October, 1997 report, literally days before the fund began its swift descent to the absolute bottom of the growth fund ratings. And what about Moretti, who promised to shareholders to stay the course laid by Johnes? Here was an easy out for everyone involved: blame it on the new guy.

I am bothered by many things. I am bothered to wake up one day to find that I own a completely different mutual fund than what I thought I owned. I am bothered that, by all appearances, Silverman gutted the Johnes/Moretti portfolio in just a few weeks time, a very bad practice, in my opinion. I am bothered that neither Silverman nor Merrill Lynch Asset Management will divulge what Silverman is up to with the fund (when Silverman was asked by a CNNfn reporter for list of the fund's top holdings, he refused to answer). In my opinion, Silverman and Merrill Lynch Asset Management have treated existing shareholders very badly, abandoning our interests without warning, and without explanation.

I am also bothered by the misinformation in the CNNfn article. Whose interest does this misinformation serve? Why would a Morningstar analyst make statements that contradict Morningstar's own mutual fund reports? Why is all the blame being laid at Moretti's feet? If blame is to passed around, surely Johnes and Merrill Lynch Asset Management deserve the lion's share of it. After all, it was Johnes and Arthur Zeikel, President of Merrill Lynch Asset Management, who signed the fund reports, which year after year detailed the fund's long term investment strategy, a strategy that Silverman appears to have violated wholesale, without any prior notice to shareholders.

A final word on the future of those energy stocks: Stephen Johnes, Arthur Moretti, and those fools like myself who stuck with the fund have a lot of company. Today, using CNNfn Online's quote service, I looked up analyst recommendations for the six largest energy holdings in the Johnes/Moretti portfolio, which comprised 28% of fund assets in the most recent annual report. In total, the recommendations are 43 for strong buy, 56 for buy, and 45 for hold. Not a single analyst gave an underperform or sell recommendation. If indeed Silverman suddenly divested the portfolio of those holdings, as it appears, I can only characterize the move as arrogant and foolish, even if energy stocks aren't his cup of tea.

Andrew Yeckel, Ph.D.



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