Highlights and Commentary
By Roy Weitz
(Originally Posted November 1, 1998 - Some editing)
[Archive Table of Contents]


Now there are six: By definition, a 3-ALARM fund has trailed its benchmark for the past 12 months, three years, and five years.....In previous editions of FundAlarm, there were no 3-ALARM international funds, because our international benchmark (Schwab International Index) didn't have a full five-year history.....This month, Schwab International Index fund celebrates its fifth anniversary, and we're now able to evaluate international funds the same way we evaluate our other five fund categories.....Here are the results: As long as we're summarizing:

BenchmarkTotal #
funds this
month*		3-ALARMNO-ALARM
Large-cap
(Vanguard Index 500)		44778%4%
Mid-cap
(Dreyfus Mid Cap Index)		15251%24%
Small-cap
(Vanguard Index Small Cap)		15539%26%
Balanced
(Vanguard Balanced Index)		10455%15%
Specialty
(FundAlarm Specialty index)		13431%29%
* In existence at least five years



Does Fidelity know we were kidding?

FundAlarm
Highlights & Commentary,
July 1998 		Hey, hockey puck! Buy this fund!
Fidelity recently hired Peter Lynch as its new media spokesperson, but he may be the wrong man for the job.....According to Barron's, Lynch has a low "Q" (recognition) rating with the general public, while Don Rickles has one of the highest.....If Fidelity really thinks that TV ads are the best use of its money, it should go all the way: Bite the bullet, hire Rickles, and start putting the "fun" back in "funds".


Bloomberg headline,
October 1998



Honey, they shrunk the fund: Over the past couple of years, FundAlarm has discussed the problems that can be created for investors by rapidly-growing mutual funds.....Now it's time to consider what happens when mutual funds reverse direction, and asset bases start to contract.....Minor contractions aren't a problem, and relatively large funds that invest in large-cap stocks should be able to handle major outflows.....But some shrinking funds, especially small-cap and emerging-market funds, raise the specter of a death spiral: Poor performance triggers redemptions, which trigger more poor performance, which triggers more redemptions.

Columnist Paul Lim recently addressed this issue,* and he concluded that investors should consider bailing out if it looks like their fund might be in the early stages of a death spiral.....As a general principle we agree with Lim, but investors should be careful not to jump from one doomed ship to another ......For example, Crabbe Huson Small Cap (CHSCX) has recently been pounded by poor performance and massive redemptions.....Investors fleeing this fund who wish to stay in the small-cap sector would probably look around for a better-performing small-cap fund, and they would probably find a fund like Fasciano.....Unfortunately, there's no guarantee that Fasciano won't be the next fund to sink, either because it hits a rough spot in the market, or because of all the new money pouring in......And if Fasciano starts to sink, and it gets hit by redemptions, investors will be tempted to flee again -- but where?

Here's what we think is a sensible approach to the problem of a shrinking fund: * "Newfound Rush to Redeem Means Risks for Investors Left in the Fund," Los Angeles Times, October 11, 1998


A bit generous with the two-thirds, but otherwise about right:

"......a lot of [mutual fund managers] are really also-rans. At least two-thirds of the people who make that sort of money don't deserve it. They've just taken advantage of a market that's only gone in the right direction."
-- Sam Stewart, head of the Wasatch funds


Booby-prize funds: Let's say you were the manager of a mutual fund, and you were relieved of your duties because your fund had performed poorly.....You'd probably tuck in your tail and find a new employer.....In most cases, that's exactly what happens with professional managers.....But occasionally, a manager removed from an underperforming fund remains as manager of another fund within the same family, or the manager is handed a new fund assignment a few months later:

This manager...was removed from
this underperforming fund		...and now manages this
fund for the same family
Anthony CraggStrong International StockStrong Asia Pacific
David FrancisEvergreen ValueEvergreen Sel. Divers. Value
Roy McKay/Peter ChinScudder DevelopmentScudder 21st Century Growth
Cindy ShieldsSecurity UltraSecurity Social Awareness
Kent SimonsNeuberger & Berman GuardianNeuberger & Berman Focus

If you currently own one of these booby-prize funds, you might well wonder why your manager is good enough for this fund, but wasn't good enough for that other one.


What have we learned this month? Thanks to Long Term Capital, the hedge fund disaster, we've learned that leverage can kill.....We've learned that investment markets bear as much resemblance to a level playing field as my backyard does to the Himalayas.....We've also learned that investment systems can blow up, even (especially?) if they've been designed by Nobel laureates.....It's unlikely that any mutual fund will ever blow up as dramatically as Long Term Capital, but the mutual fund industry does have its share of investment systems, and investors should exercise caution.....How do you know an investment system when you see one?.....Look for the tell-tale ingredients: A pinch of academic arrogance, a dash of computer gibberish, and a sprinkle of plain old-fashioned BS:

We build superior models...
Research in many fields, including financial analysis, documents an interesting phenomenon regarding expert decision making. If you can quantify enough of the key variables that an expert looks at in making a decision and do a good job of describing the analytical steps the expert takes in forming a judgment, you can build a model of the expert's decision process that will outperform the expert. This counter-intuitive finding stems from the fact that human experts often apply their judgments inconsistently. Even if the model misses some details, these are more than offset by the benefits of consistency. Investors often can't employ exactly the same standards used in judging a stock today that were used yesterday. The more details an expert has to consider, the more likely it is that inconsistencies in judgment will arise.

The investment system described in the preceding paragraph resides at Barr-Rosenberg, and it's the type of system that runs their "market-neutral" mutual funds.....Several other fund families have market-neutral offerings, and market-neutral appears to be the investment system du jour.....Like so many foolproof systems that have come before, we predict that market-neutral funds will eventually fail.....It may be a long, slow fizzle, or maybe the system will suddenly crash, and one bad year will wipe out all the good ones.....But we're pretty sure it will happen.


Well said:

"....if we don't distinguish ourselves from the indexes and from other mutual funds, we have no reason to be investors."

-- Harold Levy, co-manager of First Eagle Fund of America.
Now, if all managers would go on record with the same comment.....



A mini-rant: Balanced mutual funds performed relatively well during the recent market correction.....Some commentators would have you believe this is news, but it isn't.....In fact, it's exactly what balanced funds should have done.....If you weren't interested in owning a balanced fund before the recent correction, there's probably no reason to be interested now.....In any case, you can always create the equivalent of a balanced fund simply by dividing your portfolio between stock funds and bond funds.

Sound too easy?.....Let's say you had decided to create a home-grown, no-brain "balanced fund" three years ago.....On October 1, 1995, you put 50% of your portfolio into the Vanguard Index 500 fund, and the other 50% into Vanguard Bond Index Total......If you didn't even look at your portfolio until September 30 ,1998, it still would have outperformed 90% of the domestic funds that market themselves as "balanced"......Your risk would have been lower than 77% of the "official" balanced funds, and your combined expense ratio would have been lower than virtually all of them (99%).

One nice thing about your own "balanced fund" is that you can adjust your exposure to the stock market at will.....And don't worry if you aren't an expert at allocating between stocks and bonds.....The data suggest that professional managers aren't very good at this, either, and you have one big advantage over every professional manager: You know your own comfort level.....You should feel free to adjust your allocation between stock and bond funds to fit your needs and to fit your comfort with the market.....In the long run, you should do just fine.


"Unemployed bull seeks position in new china shop": About a year ago, tough-guy marketing wiz Paul Hondros left Fidelity for PBHG.....Hondros had big plans to shake up PBHG and turn it into an Industry Giant.....Hondros proceeded to hire a large marketing staff.....Unfortunately, the stock market did not join the Hondros team.....In mid-October, a declining market finally forced PBHG to scrap its plans for expansion, and Hondros and his staff were fired.....Hondros & Co. are presumably available to any other mutual fund company interested in being shaken up and becoming an Industry Giant.....Meanwhile, PBHG will revive a marketing strategy which was discarded last year as obsolete, but still might work: They plan to pay attention to their customers.


Please remain calm: We're entering the season for mutual fund distributions.....As in years past, most investors will probably find out about their fund's year-end distribution when they read the morning newspaper......Here's the scenario: Your fund's share price has been behaving normally, up a little one day, down a little the next..... Suddenly, and seemingly for no reason, your fund's share price takes a nosedive......If only to cushion the shock on your dropping jaw, it helps to understand what's happening.

A fund typically makes two kinds of year-end distributions: ordinary income and long-term capital gains......The mechanics of both distributions are similar, but capital gain distributions have more jaw-dropping potential, so let's briefly see how they work.....Throughout the year, your fund has been selling stocks......Long-term capital gains have been plowed back into the fund, but the tax law requires that long-term gains be distributed pro-rata to fund shareholders before each year end......The day before the distribution, let's say that your fund has a share price of $10, which includes $1 of accumulated long-term capital gains.....After the distribution, your fund's share price will drop by $1 -- 10% -- and that's the drop you'll see in the newspaper.

It's not as bad as it looks....In fact, it's not bad at all.....Despite the 10% drop in share price, the value of your investment remains the same.....If you choose to reinvest your $1 dividend, you now own 1.11 shares of the fund, worth $10.....If you take your dividend in cash, you have a share worth only $9, but you also have $1 of cash, for a total value of $10.....Unfortunately, your state of bliss may be short-lived: In a taxable account, you're required to pay tax on your distribution, whether you take it in cash or reinvest.

[An additional note: From the e-mail we receive, it's clear to us that many FundAlarm readers still track the share price ("NAV") of their mutual funds, much as they would track the share price of an individual stock.....As we've seen just above, it's impossible to calculate the performance of a fund based only on changes in its share price, once that fund has made a dividend distribution.....For performance purposes, the NAV of a mutual fund is basically meaningless.]


Briefly noted:
FundAlarm © Roy Weitz, 1998