FundAlarm - Highlights & Commentary (2/00 Archive)

Highlights and Commentary

By Roy Weitz

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

It's easier to be bad than good: The accompanying page lists all of the funds in our database that were 3-ALARM or NO-ALARM for the entire year of 1999.....382 funds make the list of chronic underperformers, while only 43 funds beat their respective benchmarks for the entire year.....Among the largest funds on the all-1999 3-ALARM List: Washington Mutual Investors, Investment Company of America, Fidelity Growth & Income, Vanguard Windsor II, and Fidelity Puritan.....Among the largest funds on the all-year Honor Roll funds: Janus Twenty, EuroPacific Growth , New Perspective, Janus Worldwide, and Legg Mason Value Prim.

[View the entire list of 1999 3-ALARM and NO-ALARM funds]

Fasten your seat belts! It's time for the annual peek at Roy's mutual fund portfolio.....Not much has changed since last year, except for the percentage allocations, but you're welcome to take a look.....Buy-and-hold investors may be encouraged by what they see, tech-maniacs will snort, and a lot of people will say "Guess what, honey? We did better than that smart-ass FundAlarm guy!"

A new offering from FundAlarm University:

210. Abnormal Psychology (I and II; 3, 2; U)

Describes the symptoms, etiologies, and treatments of the major psychological disorders. Biomedical, psychoanalytic, developmental, and cognitive behavioral approaches are explored. Prerequisite: PSYC 100 or permission of the instructor.

211. Understanding Stress Among Value Managers (I or II; 3, 0; U)

Explores the causes, manifestations, and treatment of stress among "value" mutual fund managers. Robert Sanborn, manager of the Oakmark Fund, will be our primary case study. As recently reported in The Wall Street Journal, we will investigate why Mr. Sanborn threw a Beanie Baby at his television set; how he reacts when shareholders call him a moron; how he responds when even his sister buys high-flying growth stocks; and how he manages stress by listening to the music of rapper Notorious B.I.G. We will consider the possibility that value investing is dead. We will also consider the more likely possibility that value investing will come back strong, and the almost unlimited opportunities that value managers will have to gloat, mock, and otherwise make life miserable for today's smug, know-it-all growth managers. Prerequisite: PSYC 100 or a strong stomach.

212. Emotion and Motivation (I or II; 3, 0; U)

Evaluation of theories and research on emotion. Including consideration of classical-19th century, and contemporary work. Prerequisite: PSYC 100 or permission of the instructor.

Vanguard is best known for its index funds, but it also offers an extensive lineup of actively-managed funds, most of them run by outside managers.....Because of its fund mix, Vanguard serves as an excellent laboratory for the debate over active vs. index funds.....To make comparisons even easier, several of Vanguard's actively-managed funds have close relatives on the index side.....As we see it, the issue is fairly simple: If an actively-managed Vanguard fund can't outperform a comparable Vanguard index fund, there's little point owning the active fund.....For example, consider Vanguard Equity Income, an actively-managed fund.....Vanguard characterizes Equity Income as a "large value" fund, and when we look among Vanguard's index funds it's easy to find a "large value" peer -- the Large Value Index fund .....So, how does actively-managed Equity Income stack up against its passively-managed sibling?.....Not very well:

Vanguard fund	Style box*	--- Performance as of 12/31/99** ---
Vanguard fund	Style box*	12 Mo.	3 Yrs.	5 Yrs.
Equity Income (actively-managed)	Large value	-0.19	15.39	19.89
Large Value Index (index peer)	Large value	12.57	18.75	22.82

* Per Vanguard Web site

**% annualized
Note: One of this fund's three outside managers was replaced in December 1999
In addition to Equity Income, we identified five actively-managed Vanguard funds that have obvious index peers in the Vanguard family:

Two active funds (U.S. Growth and Windsor II) have trailed their respective Vanguard index peers over the past 12 months, three years, and five years;
Another two active funds (Morgan Growth and Primecap) have also trailed their respective index peers over the past three years and five years, but have outperformed over the past 12 months;
Only one active fund, Growth and Income, has outperformed its index peer over the past 12 months, three years, and five years.

To view performance data for these funds, see the accompanying page.....Note that several well-known funds are not included in our analysis: Windsor and Selected Value are omitted because Vanguard calls them mid-cap value funds, and Vanguard does not offer a mid-cap value index.....Explorer isn't included because it's a small-cap growth fund, and the Vanguard small-cap growth index is only about 18 months old.

In a new edition, due out soon, she moves her entire portfolio into tech funds		According to a recent poll by PaineWebber and the Gallup Organization, U.S. investors have some fairly optimistic expectations.....For example, among folks less than 40 years old, investment returns over the next 10 years are expected to average 21.9 percent per year.....Investors older than 40, and those with the least investment experience, expect returns of about 23% over the next 12 months.

Nostradamus, Shmostradamus: Back in March 1998, George Vanderheiden, the dean of Fidelity fund managers, went on an extended leave of absence.....The entire episode struck us as odd, and we said so in the April 1998 Highlights & Commentary:

Something is going on with Vanderheiden......Assuming it's not health-related (and we hope it isn't), we have a strong hunch that Vanderheiden recently told Fidelity that he was leaving.....As big companies are wont to do, Fidelity is now trying to make nice.....They've dramatically cut his work load, and now they're sending him off for some belated R&R.....Our prediction: Too little, too late.....We go out on a limb: Vanderheiden will come back, find himself in the same morass, and he'll be gone from Fidelity before the end of 1999.

Early last month, right on schedule, Vanderheiden announced that he was retiring from Fidelity, effective February 1, 2000.

Our next prediction is for a period of great warmth.....Rain will stop falling from the sky, half-naked people will overrun the streets, and it will be known as summer in Los Angeles.

Vanderheiden's departure has triggered one of the biggest chain-reaction manager shuffles in quite a while.....Among the Fidelity funds affected: Advisor Growth Opportunities, Balanced, Destiny I, Equity Income II, Puritan, Select Financial Services, Select Energy Service, Select Electronics, Select Cyclical Industries, Select Biotechnology, and Select Banking .....Help, we're out of breath.....Details at Recent Manager Changes.

The smell test: This month's FundAlarm database contains 92 real estate sector funds, and the top five performers for 1999 are listed below:

	Real estate fund	1999 return
	Cohen & Steers Special Equity (CSSPX)	28.76%
	Security Cap Euro Real Est I (SEUIX)	4.12%
	Phoenix-Duff Real Est A (PHRAX)	4.12%
	Prudential Real Est Securs A (PURAX)	3.98%
	Phoenix-Duff Real Est B (PHRBX)	3.29%

Quick, now, what was your first reaction to this chart:

	(a) "Those folks at Cohen & Steers must be geniuses."

	(b) "Something smells funny about that Cohen & Steers return."

	(c) "My tech fund did better in one month."

	(c) "Ooo, what a gross picture."

If you answered (b), you have good instincts, and here's why.....As Morningstar recently reported, Cohen & Steers Special Equity owned shares of Reckson Associates Realty throughout 1999 .....Reckson Associates is a conventional REIT, but in August 1999 it spun off a new company, Reckson Services Industries (RSII).....The market decided that RSII was an Internet business-to-business play, and the stock soared from about 4 to 70 between September and December.....Most real estate funds sold their shares of RSII shortly after the spin-off, but C&S Special Equity held on to them (recently, RSII accounted for about 15% of the fund's total holdings).....Two other real estate funds -- Phoenix-Duff Real Estate and Prudential Real Estate Securities -- also held on to a significant amount of RSII and, surprise, surprise, these funds also appear on our chart of top-performing real estate funds.

Clearly, C&S Special Equity has the right to own RSII, and so far the results have been good.....But you can bet that other real estate fund managers are watching.....If performance like this continues, you can also bet that more non-traditional securities will find their way into real estate funds.....A stock like RSII raises some fundamental questions about the nature of real estate funds, and their role in individual portfolios.....If you view real estate funds as a conservative haven in a dot-com crazy world, you'll want to keep a close eye on your fund's holdings to make sure they don't start drifting in the wrong direction.....On the other hand, if you view real estate funds as a tired sector badly in need of some mojo, you probably can't wait for the next RSII, and you hope your fund manager gets there first.

Fred Froewiss, manager of the new Internet Infrastructure Fund, describing the fund's focus:		The fund is particularly interested in products or technologies that require major, long term capital investment in channel access infrastructure or unique technologies -- and which are therefore resistant to competition.
A typical investor, upon hearing the comments of Mr. Froewiss:

If you've been following FundAlarm for a while, you know that we're not a big fan of balanced funds.....Recently, however, curiosity got the best of us, and we were wondering why Janus Balanced performed so much better in 1999 than balanced funds from the other two giant families, Vanguard and Fidelity.....Now that we've finished our little research project, we're pleased to report that we have another reason to dislike balanced funds: The reporting stinks.

Janus Balanced returned 23.51% for 1999, compared to 13.61% for Vanguard Balanced Index, and 8.86% for Fidelity Balanced.....So the question seems simple enough: Why was there such a difference in returns among these funds?

Hypothesis #1: Janus Balanced held a relatively high percentage of stocks during the year, which accounted for its higher rate of return.
Confusion #1: Au contraire. Compared to the other two funds, Janus actually held the lowest percentage of stocks during the year --about 40%. Vanguard averaged about 60% stocks, while Fidelity averaged about 62%.
Hypothesis #2: The bond portion of Janus Balanced performed significantly better than the bond portfolios of the other two funds, thereby contributing to the extra Janus return.
Confusion #2: Who knows? None of the published materials for any of these funds breaks out the separate performance of their stock and bond subportfolios. At first, we couldn't believe this data was missing, and we still can't. How can any balanced fund pretend to "report" to shareholders without this crucial piece of information?
Hypothesis #3: The stock portion of the Janus portfolio was invested with a "growth" tilt, while the other stock portfolios were more value-oriented.
Confusion #3: Your guess is as good as ours. Neither Janus nor Fidelity indicates an average P/E, an average earnings growth rate, or any other measures that could help investors determine the style of its equity portfolio.

What's the explanation for the difference in performance among these funds?.....Putting together bits and pieces of information, and making some educated guesses, here's what we think is going on:

The performance of Vanguard Balanced Index is the easiest to explain. Basically, 60% of this fund seeks to track the Wilshire 5000 stock index, and 40% tracks the Lehman Brothers Aggregate Bond index. If we take 60% of the Wilshire 5000 return for 1999 (60% x 23.82% = 14.3%), and we add 40% of the return on the Lehman Bond Index (40% x -0.76%= -0.30%), we get an aggregate return of 14% for the year, which is reasonably close to the actual return of this fund (13.61%).
If we assume that the bond portions of both Janus Balanced and Fidelity Balanced were flat for the year (i.e., 0% return), then each fund's performance is entirely explained by the performance of its stock portfolio. Since Janus Balanced held 40% stocks during the year, its return of 23.51% is equivalent to a 58.8% return for a fund that was 100% invested in stocks during 1999 (23.51%/40%=58.8%). Likewise, since Fidelity Balanced was invested 62% in stocks, its return of 8.86% is equivalent to a 14.3% return for a 100%-stock fund (8.86%/62%=14.3%). In other words, the stock portion of Janus Balanced produced a decent return for a large-cap growth portfolio in 1999, and the stock portion of Fidelity Balanced produced a decent return for a large-cap value portfolio.

There you have it: Bonds appear to have contributed almost nothing to these balanced funds during 1999, and almost all of their return can be explained by their style of stock investing.....Janus performed well for a growth-oriented balanced fund, Fidelity performed well for a value-oriented balanced fund, and Vanguard fulfilled its 60%/40% mission.

There are also several lessons here for investors: The percentage mix between stocks and bonds in your balanced fund may be less important than the style in which the stock portfolio is invested.....If you already own stock funds that are tilted in a particular direction -- value or growth -- you might want your balanced funds to lean in the opposite direction......And if you really want to know what's going on with your balanced fund, you might want to construct one yourself.

Briefly noted:

Raven, the dart-throwing, Internet-stock-picking monkey, posted a 213% gain for 1999.....If Raven were a mutual fund manager, he would have ranked 22^nd in the U.S., outperforming approximately 4,600 fellow primates.....Raven, who is reportedly learning sign language, recently surprised his handlers by spelling out "Me want Ferrari."
In January 1999, Qualcomm was a mid-cap stock, verging on large-cap, and it was just starting to show some signs of life.....This was hardly an unknown company, and you'd think that dozens of mutual fund managers, who are paid to spot early stock opportunities, would have been clamoring to buy shares.....Yet only 18 funds had even 1% of their assets invested in Qualcomm at the beginning of 1999.....As of January 1, 2000, about 2,600% later, close to 200 trend-setting managers had piled onto the bandwagon.
Morningstar, January 18, 2000
Way back when, even before Ryan Jacob starred in his first role as a mutual fund manager, Kansas City Southern Industries was trying to spin its ownership of Janus into a separate company.....The spin-off has been delayed again, due to the kind of accounting issue that puts even accountants to sleep....But if this issue can't be resolved to the satisfaction of the SEC, Kansas City Southern will either have to revise its filings, which could take months, or drop the spin-off entirely.....It's also possible that the IRS will reverse its earlier ruling, and declare that the spin-off is no longer tax-free.....If that happens, the spin-off will be dead, and KCSI can finally stop its bumbling.
Mutual funds can be either "diversified" or "nondiversified".....This distinction seldom makes the news, but Vanguard Growth Index recently fell into a technical trap that received a fair amount of attention.....First, some background: Even a "diversified" fund is allowed to concentrate up to 25% of its portfolio in as few as five stocks, and these stocks can be allocated in any way the manager wishes -- for example, all 25% in one stock, 15% in one stock and 10% in another, and so on.....However, once five or fewer stocks make up more than 25% of a fund's portfolio, the fund must either stop adding to the overweighted positions, file to become a "nondiversified" fund, or plead for dispensation from the SEC.....As of January 18, four holdings of Vanguard Growth Index (Microsoft, GE, Cisco, Intel) represented more than 25% of its total assets.....Vanguard promptly filed a supplement to the fund's prospectus, informing potential investors of the issue, and the company will notify existing shareholders in the next fund report.....One thing is clear: Vanguard can't solve the problem by ceasing to buy Microsoft, GE, et al., since Growth Index would then cease to be an index fund.....Beyond that, it appears that Vanguard has only two choices: Convince the SEC to waive the diversification rule, or get shareholder approval to become a "nondiversified" fund.....Approval would be certain, if it came to that, but the process would be painfully expensive for penny-pinching Vanguard.....So, for now, Vanguard must depend on the kindness of strangers.
Steven Goldberg, of Kiplinger's, recently identified the six most "wayward" funds of 1999: Vanguard Windsor II, CGM Focus, Fidelity Advisor Growth Opportunities, GAM International, Longleaf Partners, and Sequoia....These aren't awful funds, just disappointing ones, especially in light of what investors might have expected.....Our favorite cold-comfort quote is attributed to Stanley Cates, co-manager of Longleaf Partners.....Commenting on the fund's dismal 1999 performance, Cates said that he and colleague Mason Hawkins "feel terrible. But we don't feel terrible about what we owned".....In other words, for the third year in a row, the market somehow failed to recognize the genius of the Cates/Hawkins stock-picking team.
"Stinkers of '99," February 2000; link under "Selected Web Links," at the top of this page
Readers occasionally ask if FundAlarm has any conflicts of interest, hidden sources of financing, sleazy deals, or other skeletons in the closet.....We're pleased to make the following disclosure:
Isn't fine print a wonderful invention?.....Mutual fund companies have appreciated its benefits for years, and mini-fonts are once again in great demand.....Why?.....Back in September, the SEC slapped a pesky little fine on Van Kampen funds, which failed to disclose that one of its top-performing funds in 1996 had relied heavily on IPOs to goose its return.....Today, a whole slew of fund companies are sitting on funds that were goosed by IPOs in 1999.....The companies desperately want to advertise their 100%+ returns, but they don't want a visit from the SEC lawyers....So (you guessed it): The performance numbers appear in type usually reserved for a declaration of war, and the IPO/goosing disclaimer appears in the smallest possible print that the human eye can read.

The fund firms say that the ads are "appropriate," and that they comply with all securities regulations.....The top lawyer for the SEC isn't so sure: "Basically, you can't bury things in footnotes. You can't have an ad that gives in a headline and takes away in the footnote. There has to be a balance in presentation".....Duh, he finally figured it out.....So why didn't the SEC provide some specific guidance at the time it handed down the Van Kampen fine, thereby avoiding this very predictable problem?.....Oh, wait, we know: The industry was going to regulate itself.
You'd better have a reliable connection: A new fund family, Whatifi.com, plans to rely exclusively on the Internet and e-mail to distribute fund materials and correspondence.....In order to invest in the fund, shareholders must consent to receive all information electronically.....If a shareholder revokes this consent, or fails to maintain an e-mail account, the fund can close the account or prohibit any additional investments.....Where does the weirdname of this fundfamily comefrom?.....Whatifi also plans to offer shareholders online asset allocation services, which will allow the testing of different investment scenarios (for example, "Whatifi max-out on my credit cards to buy more tech funds?").
Vontobel U.S. Value has dismal 12-month performance numbers, it's 3-year performance is barely better than a bond fund, and it has been bleeding assets (the fund is about 55% smaller than it was in early 1999).....Yet Vontobel recently imposed a 2% redemption fee on this fund, in order to discourage "hot-money" inflows and outflows.....Given the fact that U.S. Value probably hasn't seen a "hot" dollar of inflow since Monica was just another woman's name, and also given the fact that this fund would be lucky to get even a stone-cold dollar of new money, we have to wonder what the point is.....The redemption fee only applies to shares held 90 days or less, so it shouldn't prevent long-term investors from fleeing.....Maybe the fee is designed to confuse people, and make them think they can't leave.....Or, maybe, it gives manager Ed Walczak a nice little straw man: "Your fund posted really lousy numbers this year, but it would have done much better if so many investors hadn't pulled their money out. To deal with this problem, we have instituted a redemption fee".....It sounds good, and it might help take some heat off Walczak for another year or so.
You don't need a Ph.D. in psychology to know that there are two ways to influence human behavior.....You can punish people when they engage in conduct that you don't like, or you can reward people who engage in desirable conduct, in the hope that they'll continue.....Isn't it interesting that the mutual fund industry is so quick to punish short-term traders by slapping them with redemption fees, yet the industry does nothing to reward its long-term investors?.....Speaking of rewards, how about a separate, low-cost class of shares for investors who have been in a fund for at least five or ten years?.....Or, how about a special dividend for long-term investors, payable by the management company, on the ten-year anniversary of an initial investment?......These are simple ideas, yet they seem startling -- mainly because no fund company has ever thought of them.
"Mutual Funds: What's Wrong," Jeffrey Laderman, Business Week, January 24, 2000
Porky has been on vacation for the past few months, soaking up the mud in more tropical climes.....But he returns this month for a special salute to the Franklin Biotechnology Discovery Fund (FBDIX).....When this fund opened in September 1997, Franklin announced that it would be closed at $150 million of assets.....In mid-January, right about the time that the $150 million mark was met, Franklin announced that the fund wouldn't be closing after all.....Now, FBDIX is set to remain open until it accumulates $500 million in assets.....Biotech funds like this one are hot, so this is purely a fee grab.....Portfolio manager Kurt von Emster muttered some feeble comments about how the increased size of the fund will allow it to reduce its expense ratio (we doubt it).....Then, he launched into the following head-scratcher: "The size of the biotech market has gone up fourfold, so we obviously raised the size of the fund threefold or so".....Note the word "obviously" here, a technique that should be familiar to everyone who has ever been trapped by their own words and tried to BS their way to safety.....As far as we can tell, it's "obvious" only that FBDIX investors were entitled to rely on Franklin's promise, and Franklin has broken its word.
Two quotes from Benjamin Franklin, namesake of the Franklin funds:
- On reputation: Glass, china, and reputation are easily cracked, and never mended well.
- On setting an example: Well done is better than well said.
Janus Enterprise began operations in September 1992, which means that the fund has been in existence for 89 months.....From day one through the end of its 61^st month (September 1997), Janus Enterprise delivered a return that was dead-even with the S&P 500.....In the 28 months since then, Enterprise has almost tripled the return of the S&P 500 -- an exceptional performance, but one that covers less than one-third of the fund's existence.....A recent headline in Morningstar proclaimed:

"Janus Enterprise, Other Great Funds May Close"
If you're looking for signs of a market top, perhaps we can add this one to the collection: Morningstar is now hyping a fund as "great" because it has outperformed its benchmark for barely more than two years.
According to Morningstar, the other "great" funds that may soon close are RS Emerging Growth and T. Rowe Price Science and Technology.
American Airlines offers a fairly extensive line of mutual funds, under the American AAdvantage label.....Several different classes of each fund are available, including a "mileage" class that offers 1,000 frequent flier miles per year for each $10,000 invested.....Even though American Airlines is giving away its own miles, it turns out to be pretty stingy.....As a result of a higher expense ratio, each mile earned from a mileage class fund effectively costs about 4 cents.....The market value of a mile is about 2.5 cents.
The New York Times, January 16, 2000

A Disruptive manager

A midwestern stock broker and a Harvard Business School Professor (uh-oh) have teamed up to offer a new mutual fund, based on the professor's 1997 book (uh-oh)....The book, called The Innovator's Dilemma, explores how market leaders can be toppled by smaller companies with "disruptive technologies" (ho-hum)*.....The Disruptive Growth fund will apparently invest in the handful of companies that actually fit the theory, and then buy lots of other stuff that kind of fits.
* TheStreet.com, Ian McDonald, January 27, 2000

Barclay's has filed a prospectus for its new exchange-traded index funds ("iShares").....Instead of the 51 funds that were previously announced, it looks like there will be only 36 .....Offerings will include an S&P 500 index fund, which will go head-to-head with SPDRs.....There will also be funds that track the major Russell indices -- 1000, 2000, and 3000.....Rounding out the lineup are S&P 100, S&P MidCap 400, and S&P SmallCap 600 funds, as well as 14 Dow Jones sector funds (including the Internet and Technology sectors).....The prospectus indicates an "approximate" offering date of March 1, 2000.

Here's a summary of some upcoming merger activity, from an e-mail that has been making the rounds on the Internet:

Companies merging	New company name
Polygram Records, Warner Brothers, and Keebler	Polly-Warner-Cracker
3M and Goodyear	MMM Good
Hale Business Systems, Mary Kay Cosmetics, Fuller Brush Co., W.R. Grace Co.	Hale, Mary, Fuller, Grace
John Deere and Abitibi Mining Corp.	Deere Abi
Honeywell, Imasco, and Home Oil	Honey, I'm Home
Knott's Berry Farm and National Organization for Women	Knott Now
Federal Express and UPS	Fed UP
Zippo Manufacturing, Audi, Dofasco, and Daleen Technologies	Zip Audi Do-Da
Grey Poupon and Dockers Pants	Poupon Pants

...Thanks to "a good friend of FundAlarm"