FundAlarm - Highlights & Commentary Archive

Highlights and Commentary

By Roy Weitz

(Originally posted November 1, 2000) [Archive Table of Contents]

On Friday, October 13, the financial equivalent of a nuclear bomb was dropped on two Heartland mutual funds. But all is strangely quiet at Ground Zero. Here's the Q&A that doesn't appear on the Heartland Web site, and never will, courtesy of FundAlarm.

What happened? On October 13, we revalued bonds in two of our municipal bond mutual funds, Heartland High-Yield Municipal Bond Fund and Heartland Short Duration High-Yield Municipal Fund. As a result, the net asset values of the funds dropped 69% and 44%, respectively, compared to the day before.
That's a good one! You had me going there for a minute. Now, what really happened? I just told you.
But how can municipal bonds lose so much value overnight? It wasn't overnight. Our bonds had been losing value in the bond market for months. But we didn't catch on until October 13, and that's when we finally made the adjustment.
So someone -- the pricing committee, the directors, or the fund manager -- was either incompetent, negligent, or committed a fraud. How else could this kind of thing go on for months without being detected? We used an outside service to price our bonds, and their prices weren't accurate.
But isn't a fund manager supposed to know what's happening in his area of expertise? Didn't he ever look at the portfolios of other, similar funds? You mean to say that the manager didn't ever sell one of his bonds, and realize that its carrying value had been too high based on the price he could actually get for it in the open market? Are you a football fan?
What did you do when you first discovered the severity of the problem? We told the SEC: "...because of a current lack of liquidity in the high-yield municipal bond markets generally, and because of credit quality concerns and a lack of market makers, market bids and representative market transactions in the specific types of securities held by the Funds, the pricing committee presently is considering factors and information in addition to prices provided by the independent pricing service in order to assess the current fair value of the Funds' securities."
I had no idea that the high-yield muni bond market was in such bad shape. Other funds must be revaluing their bonds like crazy. No.
So this is a very serious problem for Heartland? Go Packers!

More Heartland:

Just a couple of years ago, Heartland had about $4 billion under management, and probably could have been sold for $200 million.....Today, Heartland President Bill Nasgovitz couldn't give the company away.....Talk about missed opportunities.
So, is Heartland going to be driven out of business?.....As you might expect, the plaintiff's lawyers are already circling,* and there will be many years of good feeding.....Our guess is that Heartland's survival as a company will ultimately depend on its liability insurance coverage.....If the coverage is there, Heartland will probably survive.....If not, the damage is likely to be more than Nasgovitz can handle, and the company will fold.
* NEW YORK (October 29, 2000). The law firm of Shalov Stone & Bonner has been retained by investors seeking to recover their losses in the investments in the Heartland High-Yield Municipal Bond Fund (symbol: HRHYX) and in the Heartland Short Duration High-Yield Municipal Fund (symbol: HRSDX). Investors in these funds have suffered devastating losses from the sudden and shocking revaluation of those funds. A class action lawsuit is being prepared for filing on behalf of investors in these funds. Shalov Stone & Bonner, which currently serves as a Lead Counsel for investors in the Dreyfus Aggressive Growth Fund Litigation, is experienced in the representation of mutual fund investors in actions against mutual fund companies arising from mutual fund activities.
What happens to fund shareholders if Heartland goes belly-up?.....It's an interesting question and, fortunately, there's very little precedent.....Investor money would almost certainly not be at risk, barring additional bond devaluations.....Most likely, another fund firm would take over Heartland's fund management contracts, and Heartland would be left with the liabilities.
Heartland President Bill Nasgovitz, commenting on the recent troubles at his firm:

"Some people are very upset. Some people view it as an
opportunity, believe it or not."
Not.
Tom Conlin, manager of both troubled funds, resigned on September 28. Conlin is reportedly looking to run another high-yield muni bond fund but, under the circumstances, we can't imagine that he will ever work in high-yield muni bonds again.
"This isn't the first time a Colin fund has run into trouble. He left Strong in 1995 after making a large, ill-timed duration bet with Strong High-Yield Municipal Bond Fund [SHYLX]. The bet was costly, as the fund lagged 95% of its peers in 1995."
Morningstar.com, September 29, 2000
If we owned a high-yield muni bond fund at any firm, we'd get out as fast we could. Although Heartland's problems are extreme, this is a case where the cockroach theory of investing is likely to play out -- if you see one (problem), you can be pretty sure that there are others hiding in the cupboard.

We're scared as hell, and we aren't going to do our own pricing any more: Just as all this Heartland news was hitting the fan, the Strong family of funds decided to stop pricing its own funds internally.....FundAlarm recently obtained a memo in which Strong informed its employees that fund pricing responsibilities were being taken away from Strong's in-house Fund Accounting group, and were being turned over to the State Street Corporation.....According to the memo, "as the complexities and risks of pricing our mutual funds continue to increase, it makes sense to go with a firm like State Street whose core business is mutual fund administration and fund accounting".....In case of a future lawsuit, it also probably helps Strong to have a third-party expert doing the pricing -- and State Street's deep pockets don't hurt, either.....We're assuming that Strong was planning this move before the Heartland debacle, but you've got to give them credit for their timing.

OK, so it isn't free

In January of this year, four Janus funds* bought $930 million of Healtheon/WebMD stock in a widely-publicized private placement.....A few weeks ago, after the value of the Janus stake had dropped about $750 million, WebMD filed some paperwork with the SEC which (if approved) would allow Janus to finally bail out.....Why can't Janus just dump the stock in the open market?.....Because the shares were purchased privately, they came with restrictions on their sale, and now only the SEC can lift those restrictions.....Back in January, a Janus spokesperson explained the WebMD purchase by noting that Janus portfolio managers look for companies that "have really strong management teams, have really great businesses and have the free cash to be able to execute on their business plans".....My, how things change: Now, in order to recover even 20 cents on the dollar, Janus must depend on the kindness of strangers.

* The four funds were: Janus Twenty (11 million shares), Mercury (2.4 million), Global Life Sciences (1 million), Global Technology (600,000)

The Janus loss on WebMD is equivalent to wiping out, say, the entire value of the Neuberger Berman Genesis fund.....In fact, the amount that Janus stands to lose on this one investment is larger than the entire asset base of 10,600 mutual funds.

You're an idiot: That, apparently, is the SEC view when it comes to more frequent disclosure of mutual fund holdings.....Currently, funds are required to publicly report their portfolios only twice a year....Speaking at a recent FundDemocracy symposium, SEC official Paul Roye said that the SEC doesn't want to "inundate" investors with too much information, so the SEC has no plans to push for better disclosure.....Most groups that speak for mutual fund investors would be delighted to see monthly disclosure of fund holdings, with a two- or three-month lag, yet Roye continues to worry about the ability of investors to process day-to-day portfolio information.....The fund industry has come to the point where there are simply no credible arguments -- technological, economic, or practical -- against monthly reporting of fund holdings, with a decent lag to prevent front-running.....Despite the SEC foot-dragging, one symposium participant expects that the SEC will decide early next year on a "course of action" about more open disclosure, with quarterly portfolio reporting being the most likely outcome*.....Meanwhile, Mr. Roye might want to take another look at the SEC's own Web site, especially the fancy quote that appears about 20 lines from the top of the Home page.....We've underlined what is probably the key word:

* "SEC Demurs on More-Frequent Disclosure by Mutual Funds," Catherine Valenti, TheStreet.com, October 12, 2000

Three election-season claims that should result in much blushing and averting of eyes:


"Trust me. I created the Internet."	"Trust me. I have a trillion dollars for everyone."	"Trust me. We've closed our small cap fund to new investors."

FundAlarm reader David Snowball is at it again.....This time, he turns his attention to the Turner Small Cap Growth fund, and he tries to answer the question, "Is it closed, or is it ain't?" [

Read David's article]

It's pronounced Con-sick-o: During the summer, the Conseco funds lost pretty much their entire fixed-income group to the Delaware funds.....Now, folks on the equity side are getting happy feet.....Thomas Pence, Conseco's senior investment professional (and manager or co-manager of Conseco Equity, 20, and Balanced), left in mid-October to become manager of Strong Enterprise, where he will succeed Drew Cupps.....Conseco quickly named Eric Voss, manager of Conseco 20, to assume some of Pence's duties, but -- not so fast! -- Voss announced that he was also taking a hike (joining Voss out the door were an Assistant VP and an equity analyst).....Perhaps fearing that its legal staff would also quit, Conseco decided to keep them busy by filing a lawsuit against Mr. Pence.....The exact nature of the lawsuit could not immediately be determined, but it appears to be either breach of contract or breach of niceness.....According to a Conseco spokesman, "We feel [Pence] betrayed us, our clients and our investors, and misled us. We thought he was not only a professional colleague, but a friend".....To which Pence might reply: "Hey, I got a better job".....Meanwhile, according to the Conseco spokesman, there's also some good news: "The majority of our equity investment team is still intact"

FundAlarm spy photographs confirm the good news: The majority of the Conseco equity investment team is, indeed, still intact:

Hold the hamsters: On October 23, Conseco announced that it had engaged the Frank Russell Company "to provide research, analysis and technical recommendations for the firm's equity portfolios".....The Russell disaster recovery team (technically, "transition management specialists") will occupy the two treadmills on the right until Conseco can either locate Dr. Kevorkian, or find a way to attract and retain quality managers.

To bee or not to bee: The text on the left is reproduced verbatim from a beekeeping Web site.....The text on the right is identical to the text on the left, except for a few strategic word changes:

Why does a swarm settle?		How do some fund investors decide?
"Having left its nesting site, the swarm is 'parked', while scout bees look for a suitable place to set up a new colony. Once they have found somewhere - a hollow tree, a chimney, an empty beehive - the whole swarm will take to the air again and fly to the chosen site. The 'parking' may be for a day or more, or for a few hours only. Very occasionally they remain and start to build comb. Bees often settle in a place where other swarms have been. They go for the scent the queen leaves on the place."		"Having left one mutual fund, investors are 'parked', while scout investors look for a suitable place to set up a new colony. Once they have found somewhere - a hot fund family, a new gimmick fund, a telegenic 30-something Internet fund manager - the investors will take to the air again and fly to the chosen fund. The 'parking' may be for a day or more, or for a few hours only. Very occasionally they remain and actually make some money. Investors often settle in a place where other investors have been. They go for the scent that certain financial journalists leave on the place."

It's too early to officially declare a trend, but we're starting to sniff one: Convertible technology funds.....Calamos introduced its Convertible Technology fund in September, and Ariston introduced its Internet Convertible fund in May.....Convertible securities -- bonds or preferred stocks -- are one of the strange ducks of the investment world.....When issued, convertibles pay income, like fixed-income securities.....But convertibles also carry a feature that allows them to be converted (clever?) to common stock of the issuing company at a predetermined rate.....The conversion feature typically makes sense only when the underlying stock has risen from its current price.....Traditionally, the income feature of convertibles has provided some ballast, and has also kept volatility under control, while the conversion feature has provided significant appreciation potential -- "75% of the upside and 40% of the downside" is one of the things you hear a lot about when you research convertibles.....Existing convertible funds have turned in some terrific performance numbers over the past 12 months or so, propelled in large part by their technology weightings, and many people who never looked at convertible funds before are starting to pay attention.

So what's the problem with convertible technology funds?.....Basically, lack of a track record and lack of history......With the exception of the Monterey Murphy Technology Convertible fund, a laughable 12-year old loser, no one has shown that a pure technology convertible fund can work (Murphy certainly hasn't).....And, since there hasn't been a sustained technology bear market in years, there's really no reliable data showing how today's tech convertibles are likely to hold up when things get rocky, or liquidity dries up in the marketplace.....For all we know, pure convertible technology funds may turn out to be the investment salvation of the next few years.....But the concept also carries with it just a whiff of past fund failures: A basically good idea, when part of a larger, diversified fund, that simply can't support an entire fund on its own.....Diversified convertible funds may be worth a look, especially if you're expecting a rough market ahead.....But, when it comes to pure technology convertibles, we'd be inclined to let someone else's money establish a track record.

	185 pounds youthful exuberance
	77 pounds marketing hype
	1 teaspoon investment ability

Mix these ingredients together in a large bowl, half bake for 10 minutes, and you have the Djordje Radulovic Defense/Space Age Fund, one of eleven new "synthetic" fund offerings from MAXfunds.com.....What's a synthetic fund, and who is Djordje Radulovic?.....Synthetic funds are either unmanaged baskets of stocks that Maxfunds has thrown together -- the same as "folios" -- or managed baskets of stocks that are overseen by folks with little or no investment experience or credentials.....Djordje Radulovic, for example, is a 25-year old Maxfunds employee who has taken some business school classes and has an interest in stock-picking.....With no staff, no experience, and no qualms, Radulovic has been given the responsibility for "managing" the MAXfunds basket of defense stocks.....Folks who are interested in this unique investment opportunity would presumably buy the folio's current holdings, as determined by Mr. Radulovic, and then tailor their own folios as Radulovic recommends buying or selling.

MAXfunds already uses snappy little graphics to evaluate conventional mutual funds, for example, the Fat Funds Index

, the MAXrating

, and the Expense Ratio gauge

.

Now that MAXfunds has begun sponsoring offerings like the Djordje Radulovic Defense/Space Age Fund, MAXfunds artists are busy designing additional graphics to help convey the kind of information that investors need when their fund is managed by an amateur.....Here's a sneak preview of the new MAXfunds graphics, ready to help investors understand exactly what's happening at the Djordje Radulovic Defense/Space Age Fund, as well as other amateur funds that are sure to follow:

New MAXfunds Graphics for the Djordje Radulovic Defense/Space Age Fund	Key
	Manager had bad night
	Manager had bad morning
	Manager sleeping it off
	Manager inexplicably detained
	Manager attending his child's school carnival
	Manager made dumb, rookie mistake
	Manager got lucky
	Manager confident of his strategy
	Manager attending late afternoon meeting

Briefly noted:

We're pleased to announce that FundAlarm is one of "300 Incredible Things for Women on the Internet," according to a new book of the same name.....Eat your heart out, George Clooney.

This has to be Ryan Jacob's worst professional nightmare: Not only is his Jacob Internet Fund performing poorly in its first full year of existence, it's the absolute worst-performing equity fund in the U.S., down 66.1% YTD through October 27* -- worse than any Russia stock fund, worse than any other tech fund, worse than anything.....To compound the horror, Jacob has absolutely no one else to blame.....He has made all the stock picks, he took his time getting fully invested, he set the themes, he decided to concentrate the fund's risk in relatively few holdings, and he misinterpreted the meaning of this spring's tech sell-off.....Managerial accountability is rare in the mutual fund industry, because it's usually so easy to blame someone or something else for your problems.....Jacob's failure is all the more notable because it's so pure, and because it finally lays to rest two questions that have been nagging at the country even longer than the Gore/Bush heart/brain thing:
- Does Ryan Jacob have some kind of magic stock-picking touch? No
- Did he ever? No
Beginning January 1, 2001, Real Estate Investment Trusts (REITs) will be allowed to own "taxable REIT subsidiaries," or TRS.....In many cases, these TRS will be organized to provide services, for a fee, to tenants of the REIT's properties -- for example, a TRS might provide tennis lessons to the tenants of an apartment REIT, or high-speed Internet access to the tenants of an office building REIT.....A taxable REIT subsidiary will never become the tail that wags the dog, since REITs won't be allowed to derive more than 25% of their revenue from subsidiaries, and subsidiaries won't be allowed to represent more than 20% of a REITs total assets.....Still, a poorly-run TRS could become a significant cash and energy drain on an otherwise well-run REIT, and vice-versa.....If you own shares of a real estate mutual fund, there's a good chance that you also own a sizable pro-rata interest in several REITs.....Expect many of your REITs to start deriving revenue from taxable subsidiaries, and expect discussions of TRS to start cropping up in your fund manager's reports.
Did you catch that ad for Pioneer mutual funds in The Wall Street Journal?.....We didn't think so.....Apparently undaunted by the total uselessness of every mutual fund ad that has come before, and feeling new brio after its acquisition by Unicredito Italiano, Pioneer has launched an ad campaign that is "designed to help generate greater awareness of the Pioneer brand"......After briefly considering and rejecting slogans such as "Who?" and "Huh?," Pioneer has decided to position itself as "the one" to meet a variety of investor needs.
In another strategic marketing move, Pioneer has decided to save the foam finger until later in the ad campaign:
Alberto Vilar, manager of Amerindo Technology, has become a mega-philanthropist in the opera and music worlds, personally giving or pledging about $150 million over the past five years.....One of his smaller gifts ($2 million annually) sponsors a visiting artist series at his alma mater, Washington & Jefferson College, where Vilar has also kicked in $5 million toward the Vilar Center for Technology.

We had never seen Vilar referred to as "Dr." before, so we did some investigating.....Turns out that the doctorate in question is an honorary degree from (you guessed it) Washington & Jefferson College.....Here's a guy worth -- what? -- $500 million, and he still feels the need to pad his resume with a meaningless degree..... Don't you just love these little insights into managerial personality?

Michael Fasciano has finally thrown in the towel, and he will allow his Fasciano fund to be acquired by Neuberger Berman.....For 10 years or so, Fasciano labored in successful obscurity.....Then, a couple of years ago, Fasciano was discovered by the financial press, new money poured in, performance suffered, new money poured out, and Fasciano probably thought more than once about that old proverb, "Be careful what you wish for, because it may come true".....Neuberger is delighted with the acquisition, because Neuberger gets to fill one more box on the style grid (mid-cap blend) which, ultimately, is what modern mutual fund companies are all about.....Predictably, Fasciano says that the new arrangement will allow him to spend more time doing what he does best, which is managing money, and less time handling the administrative and marketing aspects of his fund.....Our big question: Even with all the support in the world, is Fasciano capable of successfully managing $240 million (the current size of his fund)?.....Or is Fasciano the kind of manager who's perfect for a small fund, but can't handle a larger one?.....Fasciano's first few months with Neuberger should be very telling: If the fund doesn't quickly straighten out, we have our doubts that it ever will.

The Kaufmann managers

Federated Investors has agreed to buy the Kaufmann Fund for $100 million per pair of suspenders, plus another $100 million per pair of suspenders if certain revenue targets are met.....This is believed to be the highest price, per article of clothing, ever paid for a mutual fund.....In dollars, this works out to $200 million up-front, plus about $200 million if all contingencies are met, which would represent a total purchase price equal to 10.8% of Kaufmann Fund assets -- an astonishing amount, and more than twice the going rate for even a quality mutual fund .....Why would Federated agree to pay twice the going rate for a mutual fund?.....Dear reader, this is not a trick question: It's because Kaufmann's expense ratio is at least twice what it should be, and Federated feels pretty confident that it will be able to squeeze from Kaufmann investors in the future whatever it overpays for the fund today.

More cash register news: Allianz AG, a German insurance company, has agreed to acquire Nicholas-Applegate, which sub-advises several mutual funds.....ABN Amro, the largest Dutch bank, will acquire Alleghany Asset Management, which manages 13 Alleghany fund through several investment advisory units (Montag & Caldwell, Chicago Trust, Veredus Asset Management, and Blairlogie Capital Management).....The names of the funds also will be changed, which is not necessarily a bad thing, since these were some of the least euphonious names in the fund business (how about "Alleghany/Montag & Caldwell Balanced N" to get your blood pumping?).

Here's an interesting coincidence, and we don't know exactly what to make of it: The average return of all real estate funds in this month's FundAlarm database is almost identical to the average return of all energy/natural resources funds:

Specialty fund area	FundAlarm benchmark	# of funds included	Avg. 12 Mo. Return (%)	Avg. 3 Yr. Return (%)*	Avg. 5 Yr. Return (%)*
Energy/Natural Resources	Specialty-NatRes	61	22.15	-0.66	10.15
Real Estate	Specialty-RealEst	108	21.76	-0.65	10.28

* Annualized

In a recent interview with Morningstar.com, Scott Schoelzel (manager of Janus Twenty) went out of his way to keep Janus investors calm.....According to Schoelzel, Janus fund managers are now comfortable being part of Stillwell Financial, Jim Craig's departure had been expected (and isn't disruptive), and there will be no mass exodus of top Janus managers.
"Janus Speaks," Christine Benz, Morningstar.com, October 10, 2000

So, how should investors respond to Schoelzel's assurances?.....As it turns out, Schoelzel has a track record of trying to keep Janus investors calm, as we reported in the June, 1999 issue of FundAlarm:

"When Scott Schoelzel took over the reins of Janus Twenty [from Tom Marsico, in August 1997], he went out of his way to keep investors calm .....Schoelzel told SmartMoney magazine (October 1997) that there was "a tremendous amount of commonality" between Janus Twenty and Janus Olympus, which Schoelzel had just left.....Schoelzel also assured the magazine that his methods "won't differ much from Marsico's".....In a [May 1999] interview with Bloomberg Online, Schoelzel apparently felt comfortable enough to finally tell the truth.....In his first 90 days at Janus Twenty, Schoelzel acknowledges that he eliminated or reduced about half of the fund's holdings.....In fact, at the same time Schoelzel was telling SmartMoney that little would change, he knew exactly what he planned to do: "Tom Marsico taught me, when you take over a fund, you clean house".

In other words, Schoelzel has been known to calm at the expense of the truth.....We shall see.

Smart guy is interested in the stock market.....Smart guy creates quantitative computer model that allegedly captures everything there is to know about stocks.....Smart guy starts mutual fund.....Smart guy's computer model (and fund) perform well for a while.....Smart guy gets lots of press, and some people think "Maybe this is the stock model that finally works".....Smart guy's model fails, the fund crashes, and everyone moves on to the next infallible stock market model.....If it seems like you've heard this before, you have, and (except for the failure part, at least so far) it pretty accurately describes the Alpha Analytics Digital Future Fund.....In this case, the smart guy is John Gipson....There's also a non-quantitative part to this fund -- a human tech analyst (Michael Cohen) who initially selects the stocks for screening by the computer model -- and the human part makes this fund even more certain to take a dive, since humans invariably mess up whatever discipline a quantitative model might otherwise impose.....Gipson's modus operandi is to take Cohen's picks, crank nine to 12 months of past performance into his computer, and "forecast" what those stocks will do next month.....Among the 70 variables that are reportedly included in Gipson's computer model, we assume that he has somehow captured the mood swings of Yassir Arafat, the intentions of OPEC, and the inclinations of Alan Greenspan.