IS IT TIME TO Clean House?

By TOM PETRUNO and KATHY M. KRISTOF

Oct. 6, 1996 12 AM PT

TIMES STAFF WRITERS

If your mutual fund portfolio has begun to resemble your junk closet at home--or worse, a college dormitory refrigerator--consider this an invitation to a clean up.

Unorganized, unfocused, unwieldy fund portfolios have become an unwanted status symbol for many investors in 1996. Egged on by Wall Street’s long bull market, Americans have bought mutual funds in record amounts, and in an incredible array of flavors, for most of the last six years.

And why not?

For the typical stock fund investor, things just keep getting better: The third quarter produced the seventh consecutive quarterly gain for the average U.S. stock fund, a 2.6% rise that belied the summer’s brief but violent market downturn.

Yet all of that fund buying, along with relatively little selling, has left many investors with portfolios they can’t explain and that often don’t fit their long-term goals, say financial planners who deal with more such confused “patients” every day.

“We see this all the time,” said Daniel P. Wiener, president of Adviser Investment Management in Watertown, Mass. “The prevailing problem is that people get it in their head that if one [type of fund] is good, then four of the same will be better.”

The temptation to buy more is everywhere: Corporate 401(k) retirement plans are increasingly adding more fund options for participants; discount brokerages such as Charles Schwab Corp. and Jack White & Co. offer easy access to hundreds of funds; and in every major financial publication, including this one today, there is a quarterly roundup detailing what’s hot among fund categories.

So far this year, for example, investors’ appetites have increased most dramatically for gold funds, global stock funds and balanced (stock and bond) funds, as measured by the percentage increases in gross purchases of those funds compared with the first eight months of 1995.

Are those fund categories filling big gaps in investors’ portfolios?

Maybe. Or it may be that they just gave investors more things to worry about in June and July, when stock markets worldwide suddenly took a spill and the U.S. market suffered its deepest decline since 1994.

Now recovered, the bull market is presenting investors a gift of sorts: You have a chance to think about what you own, why you own it and whether your fund portfolio truly fits your goals and your tolerance for risk.

Most important, this is a great opportunity to clean house, eliminating needless duplication of funds, dumping rotten performers and simplifying your portfolio so that it--and you--can follow a plan to long-term financial success, regardless of the markets’ next turn.

Even if you own just a handful of funds, you can benefit from a portfolio review. It can keep you focused and help you avoid the temptation to buy funds willy-nilly as your ability to invest increases.

Start With an Inventory

How diversified are you really? How diversified do you want to be?

There is no single magic mix of assets that’s right for every investor. Beginning investors might own just one stock mutual fund because that’s all they can afford. But as your experience and income permit, it’s natural to want to diversify your assets among a variety of investments.

The first step in any portfolio housecleaning is to do a full inventory: Make a list of all of your financial assets, including investments owned in 401(k) plans or similar payroll plans, tax-deferred annuities and individual retirement accounts, individual securities and mutual funds owned outside of retirement accounts and bank or credit union savings.

List each asset in one of four categories: stocks, bonds, balanced (for funds that mix stocks and bonds) and “cash” (for money market and bank savings). Total the categories, then calculate the percentage of your total assets in each category.

Generally, the younger you are, the more comfortable you should feel having a high percentage of your financial assets in stocks--perhaps as much as 90%.

Older investors may feel more comfortable having a hefty percentage in more conservative assets such as bonds and balanced mutual funds.

Your specific mix should fit your ability to handle risk. The simple rule to keep in mind is that your stock assets absolutely offer the best long-term growth opportunities, but they also could temporarily lose 50% or more of their value in a severe market downturn. Knowing that, you should keep as much in stocks as you can stand. But never be too dependent on one stock--such as your employer’s in your 401(k) plan.

No matter what your age, focus on what you want to achieve long-term with your money. Admittedly, that’s a challenge.

“Most people have a tough time imagining what’s going to happen in a couple of weeks, not to mention planning decades ahead,” says Tim Kochis, a certified financial planner with Kochis & Fitz in San Francisco. But in reality, many financial goals are exceptionally long-term in nature, he notes.

Even retirees need to realize that at age 60 to 65, they should be investing with a 20- to 35-year time horizon because life expectancies have lengthened greatly, Kochis points out. That requires a growth-investing mentality, which means stocks, he says.

“I ask [clients] if their parents are still living. Are their grandparents still alive? Then I ask them how long they think they’re going to live,” Kochis says.

It is, he says, an eye-opening experience for people.

Remember, It’s What You Keep

Invest with the idea of protecting your nest egg from two ever-grabbing hands: taxation and inflation.

Focusing on what you keep quickly shows you why holding too much of your assets in cash accounts is a mistake: It’s “safe,” but there is little left of your earnings after Uncle Sam and inflation.

Consider: The average money market mutual fund yields 4.8% now. In the 40% combined federal and state marginal tax bracket, the government takes 1.9 percentage points of that yield, leaving you with a net yield of 2.9%. And with inflation running at about 3%, your “real” return is nothing.

Even if most of your assets are already in stocks and bonds because you understand that’s where you have the best chance of beating inflation long-term, there is another issue to think about: How “tax-efficient” is your portfolio?

If you’re saving for retirement, you should shelter as much of your assets as possible from taxes now so that your nest egg benefits fully from compounding.

You can do so by making the maximum contribution to your 401(k) retirement plan, of course, and by using tax-deferred annuities. As a practical matter, if you own two similar stock funds, one inside a 401(k) plan and one outside, it may be smarter to raise your 401(k) contribution than to invest regularly in the non-tax-sheltered fund.

If you are worried about having too many assets locked up in retirement accounts that penalize early withdrawals, you may want to consider some portfolio rearranging.

For example, it makes sense to own bonds and other high-income-generating investments in tax-sheltered accounts rather than in non-tax-sheltered accounts, because current income is taxed at regular tax rates.

On the other hand, it may be less critical to shelter individual stocks you plan to hold indefinitely (you don’t pay taxes on any gain until the stock is sold, after all). And in any case, because long-term capital gains are taxed at a lower rate than regular income, investors with stock mutual funds that pay out capital gains yearly sacrifice less to the tax man than investments paying interest.

What Kind of Stock Funds?

The easy decision is to be in stock mutual funds. Deciding the right blend of styles is the hard part.

The riskier the fund, the higher the returns should be over time. Interestingly, it appears that many investors have been quite willing to raise the level of risk they’re taking in mutual funds over the last few years.

Through August, gross purchases of aggressive-growth stock funds--which tend to focus on smaller, faster-growing stocks that also are more volatile--have zoomed 76% from 1995 levels to $65.3 billion, according to the Investment Company Institute.

Funds that invest globally also are far more popular this year, with gross purchases up 78%.

Should investors be assuming more risk with stock prices worldwide up sharply over the last 20 months? Given that many investors probably have been too cautious with their assets over the last decade, the growing popularity of higher-risk funds may not be terribly alarming, some experts say.

In fact, financial planners say they often end up reallocating a bigger share of new clients’ assets into faster-growing, albeit riskier, stock funds.

“Have people been too conservative? Definitely,” says certified financial planner Gale Campbell-Johnston at AFP Group in West Los Angeles, reflecting on new clients’ portfolios.

For example, despite the new allure of aggressive-growth funds (a category that includes so-called capital appreciation funds), they still hold just 15.8% of total stock fund assets. The largest share of assets--40%--is in growth-and-income and equity-income funds that tend to favor safer, blue-chip stocks.

Growth funds, the middle ground between growth-and-income and aggressive-growth, hold 27.4% of stock fund assets. And global and international funds have just 16.4%.

There is no single mix of stock fund styles that is right for everyone. But many financial pros suggest investors start an orderly and sensible portfolio with one blue-chip fund, one aggressive-growth fund and one global fund, owned in equal proportions.

In this now nearly all-capitalist world, some investment advisors say it still surprises them how many investors are missing a foreign-stock fund.

“Lack of international exposure is something that we see a lot of,” Kochis says. “Most American investors have this completely parochial view of the world’s capital markets. We see them with all their investments in the United States, in addition to their house and their job.”

It’s true that the U.S. economy and the U.S. stock market have been healthier than many foreign economies and markets in the 1990s. The average U.S. stock fund is up 97% over the last five years, compared with 59% for the average international fund. Considering the greater volatility in foreign stocks and the threat from fluctuating currencies, that’s a poor foreign showing.

But 59% is still better than the 21% average return on money market funds over the last five years. And with many foreign companies only now beginning to cut costs and restructure the way U.S. companies have done, there is arguably much more potential in foreign stocks going forward.

What About Bond Funds?

One of the biggest debates in the financial planning industry in recent years has been over bonds.

Bonds are supposed to provide an element of stability in a portfolio, because by virtue of the fixed interest yields they offer, they generally can’t suffer the massive loss of value that stocks can suffer in short periods.

But bonds and bond mutual funds temporarily lost enough value in 1994, when market interest rates soared, to sour a large number of conservative investors. The average long-term U.S. Treasury bond fund had a negative total return of 4.6% in 1994, as the principal devaluation of older fixed-rate bonds because of higher interest rates more than offset the yields those bonds paid.

Although 4.6% is a small decline all things considered, investors have yanked massive sums from Treasury bond mutual funds: In 1989, Treasury and government-guaranteed mortgage bond funds held 36% of total bond fund assets. Now they hold less than 16%.

For investors who still want to own bonds, there has been a marked shift toward non-Treasury funds--in particular, toward “flexible” or balanced funds that mix stocks and bonds, and toward funds that mix in or focus on corporate high-yield, or junk, bonds.

Financial pros say the shift toward balanced and flexible funds suggests investors are willing to take more risk for more return. But some experts wonder if investors are buying balanced funds purely as bond fund substitutes, thinking that a balanced fund will provide a good buffer if stocks plunge.

Depending on the amount of stock a balanced fund owns, that hoped-for buffer may fail.

In choosing a bond or bond-like fund, “you have to figure out what you want that fund to do for you,” says financial advisor Wiener.

The fact is, bonds still lend stability to a portfolio--something that surely will be treasured when the next stock bear market arrives.

Some investors have jettisoned bond funds in recent years for a simpler approach: Owning Treasury notes and bonds directly, in “laddered” maturities (say, one, three, five and seven years). It makes for an uncomplicated bond portfolio because you know exactly what yields you’re getting, and you get all of your principal back at maturity, something bond funds can’t guarantee.

Still, the key with bonds is to avoid overdoing them. They aren’t growth investments. “I never go over 30% bonds [in a portfolio], and I like to keep it to 20%,” says advisor Campbell-Johnston.

Finally, although tax-exempt municipal bond funds are the single most popular bond fund category, many experts wonder why they aren’t even more so. For higher-tax-bracket investors, munis’ tax-free yields leave you with more income than Treasury bonds.

Avoid Pack Rat Syndrome

Mutual funds aren’t collectibles, but they often become so over time with investors who get into the habit of buying the flavor of the month.

A survey this year by the Investment Company Institute found that 28% of fund investors now own four to six funds, and 15% now own seven or more.

The survey didn’t include investors who own funds only through 401(k) plans. Within those plans, the average number of investment options held was 6.3 as of last year, up from 4.9 in 1993, according to Access Research.

How many funds is too many? There is no right or wrong number. But with every fund in your portfolio you should be able to answer two simple questions: Why do I own this? And how is this different from other funds I own?

Consider Sam, a well-heeled Angeleno who consistently bought “hot” mutual funds--the ones featured in financial magazines as “the best funds to buy now.”

Over the course of a few years, she had accumulated more than a dozen funds and thought she was well-diversified as a result.

But when Patricia A. Johnson, vice president for investments at Smith Barney in Beverly Hills, recently analyzed Sam’s portfolio and that of another investor that included 18 funds, she found that 40% of these clients’ assets were in just one asset class: small-company stocks.

“In the summer, when the market dropped and small growth stocks declined dramatically, these people had fairly sizable losses,” Johnson says. “They woke up and said: ‘Wait a minute here. I thought I was being conservative and diversified.’ ”

In fact, having a lot of funds doesn’t necessarily make you diversified. It does, however, mean you’re paying management fees to many different fund companies, and it increases your record-keeping and tax-preparation headaches.

Johnson’s solution for her two fund-overloaded clients was to cut their holdings to five or six solid funds in different investment categories: big stocks, smaller stocks, bonds, international investments and money market.

“If you have five funds in different asset classes, you have diversified,” Johnson says. “You don’t have to keep adding to your stable of funds. You add money to the funds you’ve selected. Just make sure that what you’ve got is working.”

Her final point is key: You don’t really need four separate blue-chip stock funds; what you need is one blue-chip fund that performs well.

Of course, some investors justify owning “duplicate” funds by arguing that they fear picking one in a category only to see it flop. But the more you duplicate and the greater the number of funds you own (particularly specialty funds in single industries), the greater your risk of creating a portfolio that will do no better than average. And for that, you might as well just own a low-cost, passive market “index” fund instead of paying fees to active managers to get you much the same result.

Learning to Let Go

Selling an investment is always the toughest decision. But if it’s time to clean house, you probably know it in your heart. Either your portfolio has simply become too unwieldy or too dependent on one type of asset, or you are avoiding addressing what to do with specific funds because they have performed poorly and you don’t want to admit you picked losers.

If you can’t think of a good reason why you own something, it’s probably time to let go of it. If a fund has under-performed the average fund in its category for three years, it probably is time to sell and buy a better fund, many financial pros say. (Much of the data you need to evaluate your funds are in today’s Business section.)

Your goal should be to have a portfolio you can easily keep track of and--most important--that achieves for you over time a level of return matching the risk you’re willing to take.

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What’ Hot in ’96

Here are the stock and bond mutual fund categories that have shown the biggest percentage rise in gross investor purchases this year.

Stock Funds

Fund type: Gold

1996 gross purchases (billions): $2.6

Percentage change from ‘95: +88%

Fund type: Global

1996 gross purchases (billions): $18.0

Percentage change from ‘95: +78

Fund type: Aggressive- growth

1996 gross purchases (billions): $65.3

Percentage change from ‘95: +76

Fund type: Growth

1996 gross purchases (billions): $82.1

Percentage change from ‘95: +70

Bond Funds

Fund type: Balanced

1996 gross purchases (billions): $13.7

Percentage change from ‘95: +55%

Fund type: Corporate

1996 gross purchases (billions): $5.8

Percentage change from ‘95: +49

Fund type: Corp. / govt.

1996 gross purchases (billions): $20.4

Percentage change from ‘95: +47

Fund type: High- yield

1996 gross purchases (billions): $14.0

Percentage change from ‘95: +46

Note: Date measure gross purchases through August, excluding reinvested dividends.

Source: Investment Company Institute

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How Typical Are You?

Here’s a look at mutual fund ownership by the numbers- number of funds owned by investors, the most popular fund categories by asset size and how 401(k) retirement plan assets are divided among various assets, including funds.

How Many Funds Owned?

Twenty-eight percent of mutual fund investors own four to six funds, and 15% own seven or more funds, a 1996 survey by the fund industry shows.

One: 20%

Two: 21%

Three: 16%

Four to six: 28%

Seven or more: 15%