Fund Orderliness Is the Manager’s Row to Hoe

If investors visualized mutual funds as vegetable gardens, they might have a better idea of what they own.

With some funds, they would find the stock or bond holdings arranged in neat, carefully labeled rows just the way the prospectus described them--technology and small stocks over here, utility and other high-dividend issues over there.

But with other mutual funds, they would find that the investment picks had been planted in no particular order--a patchwork of disparate securities springing up side by side like shrubs in a forest clearing.

The issue of portfolio cohesion and orderliness is a big one for mutual funds these days. Investors want to know with reasonable certainty that portfolio managers are sticking to their knitting.

When the giant Fidelity Magellan Fund revealed early in 1995 that portfolio manager Jeffrey Vinik had amassed a 45% weighting in technology stocks, it showed how unpredictable a fund’s composition could become.

When investors learned that Vinik had staked a quarter of Magellan’s assets in bonds in early 1996, it sparked another round of questions that may have led to his eventual departure from the firm.

The orderliness of any particular mutual fund depends on the buy and sell decisions of the gardener himself--the portfolio manager. Such decisions can be highly individualistic.

R. Lynn Yturri, who manages two large-stock portfolios for the Columbus, Ohio-based One Group family, enjoys a lot of personal discretion over which stocks to buy or sell, although he recently hired a co-manager.

“What I buy or sell is based on my appraisal of individual stocks,” says Yturri, who works in Phoenix. “I just enter an order on the computer and it sends the information back to Columbus, where they trade it.”

But at the Seneca family of mutual funds in San Francisco, stock ownership decisions are much more of a group effort. A team of eight portfolio managers, analysts and researchers figure out which stocks to buy or sell after a group discussion, with input from the firm’s in-house traders.

The offices of equity team members are arranged around a trading floor so that when stock research reports, earnings releases or other information comes in, the group can meet on an ad hoc basis to decide the fate of this or that company.

“We tend to make trading decisions quickly,” said Managing Director Eric Munson. “When we make a decision, we don’t sit back and second-guess it.”

Seneca targets rapidly growing corporations, but it limits any industry’s weighting in the funds to no more than double that of the Standard & Poor’s 500.

Not so at Davis Selected Advisers, a Santa Fe, N.M., fund family with offices in New York. Co-managers Shelby and Christopher Davis, a father-son team, load up on the best bargains they can find, moving slowly and without worrying about industry weightings.

Some managers make adjustments, typically around a quarter’s end, to push a fund’s industry holdings back in line with some index, says Christopher Davis. “But we feel re-balancing amounts to watering the weeds and pulling up the flowers, because you’re buying more of the losers while selling off the winners,” he says.

The Davis funds tend to hold each stock about six years on average, “so the sell decision is not something we take lightly,” he says.

Of all the types of mutual funds, index portfolios tend to be the most orderly, predictable gardens. These vehicles try to replicate the performance of popular market gauges such as the S&P; 500 and thus will hold all, or at least most, of the same issues.

But even here, the buy and sell process doesn’t work to perfection.

Take the Vanguard Index Trust 500, which targets the S&P; 500. Even this giant fund, which frequently takes in $20 million from investors in a day, can’t buy all 500 companies on a daily basis. Instead, it might purchase 100 to 150 issues one day and the rest on subsequent days, says Gus Sauter, a Vanguard principal in Valley Forge, Pa. Sell decisions are made in reverse, based on shareholder cash outflow on a given day.

But for index funds that hold small U.S. stocks--many of which are costly to trade in small quantities--Vanguard buys a sampling of companies rather than the entire basket. For example, the Vanguard Index Total Stock Market Portfolio targets 7,000 companies, but the fund holds only 2,500 or so, and it might trade just a few hundred on a given day. Vanguard relies heavily on computers to select samples of stocks that move closely in line with the appropriate market benchmark.

International index funds can be even more troublesome because stock markets in Asia and Europe close each day before money from Vanguard investors pours in. This means the firm has to base buy and sell decisions on predicted, rather than actual, cash flow from shareholders.

When it comes to measuring mutual fund trading activity and orderliness, investors have several tools at their disposal. They can peruse the list of holdings in the fund’s annual and semiannual reports and read management’s letter to shareholders. Also, they can check the portfolio turnover numbers and the fund’s investment objective in the shareholder reports or in the prospectus.

“When we search for stocks, we look for corporate managers who have been successful in running a business in a consistent way over time,” says Davis. “As an investor, I’d also want a strong sense of how my fund manager is making decisions.”