In Case of Emergency . . .

Within hours after the stock market’s 554-point plunge on Oct. 27, the red-and-white Swiss flag was hoisted above the headquarters campus of Vanguard Group, the mutual fund giant.

It was the signal mobilizing Vanguard’s “Swiss Army”--a rapid-deployment force of 1,000 managers who can instantly be switched from their regular jobs to telephone duty when a market event creates a flood of calls.

Vanguard knew that the best way to stem panic was to ensure that customer calls would get through. Like other major fund groups, it had planned extensively for doomsday even while investors were enjoying a seemingly invincible bull market.

As events unfolded that final week in October, the feared rout never arrived, but the stakes today have never been higher for the nation’s mutual fund industry and its 63 million customers.

Mutual fund assets now total $4.3 trillion and are held by 37% of U.S. households, according to the Investment Company Institute, a mutual fund trade group. This vast reservoir of savings--more than one-third of it held in retirement accounts--is considered as stable as any pool of money on Wall Street. Still, its sheer volume makes experts worry about the consequences should it ever start flowing rapidly in the wrong direction.

Nobody knows what might cause the dam to burst, but faced with a torrent of redemptions--cash-in demands--fund managers could be forced to dump stocks at any price, accelerating a downward spiral.

Although all fund groups have worked to shore up the gaps exposed by the infamous stock market crash of 1987, few take disaster preparedness to greater lengths--and few have been more open about their plans--than Vanguard.

‘Constructive’ Paranoia

On the night of Oct. 27, Vanguard Chairman and Chief Executive John J. Brennan rushed from Washington back to suburban Philadelphia to prepare for whatever might come the next morning.

Like Vanguard founder and Senior Chairman John C. Bogle, Brennan occasionally dons a phone headset with the rest of the “Swiss Army.” (In choosing the name, Bogle was inspired by Switzerland’s all-volunteer citizen army.)

To make room for the extra bodies needed on the phones, Vanguard also readied the “hot site”--an alternate work area for up to 300 people in the company’s bunker-like data center five miles from headquarters.

Mutual fund holders were among the coolest heads in the market that week, refusing to sell out on Monday and buying enthusiastically on Tuesday to help fuel a 337-point rebound in the Dow Jones industrial average.

Despite a record 75,000 calls on Tuesday, Vanguard said it met its goal of limiting average “hold time” to 15 seconds.

Brennan, who “took a bunch of calls” that day, said he saw no sign of panic.

Yet he acknowledged in an interview that had stocks dropped again Tuesday and tripped another “circuit breaker” like the ones that twice halted trading on the New York Stock Exchange during Monday’s plunge, the bull market that is still going today might have taken a far different turn.

With the Asian financial crisis apparently easing and the prospect of war with Iraq at least temporarily defused, the stock market is in another feel-good phase.

This is precisely when money managers like to paint worst-case scenarios. As Brennan put it: “We’re always constructively paranoid.”

Black Monday

The closest the mutual fund industry has come to catastrophe was the crash of Oct. 19, 1987, when the stock market lost 22% of its value in a single day. The crash triggered redemptions exceeding $10 billion, or 4.5% of all stock mutual fund assets at the time.

In surveying the damage afterward, the industry concluded that it hadn’t exactly covered itself in glory. Among the problems on Black Monday:

* Phone systems were overwhelmed by the surge of calls, which pumped up the anxiety of the many investors who couldn’t get through.

* Computers that processed stock transactions were swamped by huge trading volume. The electronic gridlock made it impossible for funds to post end-of-day prices, again leaving worried customers in the dark.

* Fund managers themselves were unable to get some trades executed because dealers in certain stocks were either too busy to respond or simply ignored calls.

“Sometimes panic occurs just because you can’t get through,” said John Markese, president of the American Assn. of Individual Investors, adding: “ ’87 woke everybody up.”

Sheldon Jacobs, publisher of the No-Load Fund Investor monthly newsletter, thinks the likelihood of a panic may be exaggerated. “If we had an ‘87-type crash today, I don’t think the redemptions would be as bad,” he said.

On the other hand, there’s no law that says investors will keep “buying on dips” and pulling the market back up when it drops. “One day, the market is going to go down 5%, 6%, 7%, and instead of snapping back the next day, it’ll go down another X%,” Jacobs said. “That’ll be the end of that strategy!”

Defense Mechanisms

The Vanguard campus lies amid rolling hills a few miles from Valley Forge, where Washington’s army spent the cruel winter of 1777. But the prevailing military references--in paintings, logos, the names of the buildings, the name of the company itself--are to the Napoleonic Wars, a longtime passion of Bogle’s. (HMS Vanguard was the flagship of British Admiral Horatio Nelson.)

Within the walls, the “constructive paranoia” that Brennan described seems to pervade every decision.

“We try to select our own client base. That is the first step in contingency planning,” said James H. Gately, the executive in charge of Vanguard’s individual investor group.

“If we’ve selected properly,” he added, “we’ll have less trouble when an event comes.”

A fund group doesn’t grow to Vanguard’s size--$300 billion of assets under management--by turning away hordes of customers, of course. However, Vanguard does try to discourage market timers--investors who like to jump in and out--by limiting the number of “round trips,” or purchases and sales of a single fund, to two per year, Gately said.

Market timers hurt fund performance by adding transaction costs. Also, from a defensive standpoint, they represent “fast money” that disappears at the first sign of trouble. Cutting jittery cattle out of the herd before a storm is good insurance against a stampede.

Once customers are on board, Vanguard plies them with literature that keeps sounding a long-term, buy-and-hold theme and tries to wage war against euphoria.

Last spring, for example, Vanguard sent investors a cheerless little pamphlet titled “Bear Markets: A Historical Perspective on Market Downturns.”

The Force Be With You

Unlike rival Fidelity Investments, Vanguard lacks a national network of retail offices. The telephone system, therefore, is both Vanguard’s front door and its primary line of defense against a market panic.

The best-known element of that defense is the “Swiss Army,” which enables Vanguard to double its phone-answering force.

To build esprit de corps, Vanguard hoists the Swiss flag when the force is on duty. Inside the office complex, miniature Swiss flags fly from cubicles here and there to designate Swiss Army training areas, where the troops get regular brush-up sessions on handling investors’ questions.

Electronic scoreboards on the walls around the office blink out a running tally of phone representatives on duty, callers on hold and other statistics.

The numbers are taken seriously. Meticulously logged each day, they figure in work-force planning as well as supervisors’ job evaluations and bonus pay.

The phone reps don’t work from a script, but when there is market turmoil or an important news event, Vanguard executives send the staff e-mail memos with talking points to help them answer investors’ most likely questions.

Such commentary, plus news bulletins, market statistics and customer account information, can be quickly pulled up on the reps’ computer screens.

According to Gately, only 20% to 25% of calls involve purchase or sales orders; most of the rest are for information and housekeeping matters such as address changes and setting up direct-deposit accounts.

The idea is that if customers can get questions answered quickly and calmly, they are less likely to make rash decisions.

“Very often,” said Gately, “reassurance is what they’re really looking for.”

They can’t prove it, but some Vanguard executives believe the lack of a phone logjam was partly responsible for the firm’s customers logging more “buys” than “sells” over the two days of frenzied activity last October.

Other fund groups reported similar results, which the industry presents as evidence that if there was panic in the markets that week, mutual fund investors weren’t part of it.

Quick Access to Cash

Since 1987, many fund companies have erected financial barriers against what might amount to a “run” by worried customers.

From a safety standpoint, it would seem ideal to have a fat cash balance to meet any conceivable wave of redemptions. But funds have to maintain a balance between performance and safety. Investors buy equity funds because they want equities--not cash.

When stocks are soaring, therefore, no manager wants to be sitting on a pile of cash. They remember what happened to Jeffrey Vinik, ousted in mid-1996 as chief of Fidelity’s flagship Magellan Fund--the nation’s largest mutual fund--because he defensively reduced the portfolio’s stock holdings and missed a terrific run-up.

On average, U.S. equity funds now have about 5.5% of their assets in cash, according to the Investment Company Institute. That’s a thinner cushion than the industry kept at the time of the 1987 crash, when funds held about 7% in cash.

Since Black Monday, however, fund groups have devised new strategies to get quick access to cash while staying nearly fully invested in stocks.

At Fidelity, for instance, funds are allowed to borrow cash from one another to meet redemptions. Vanguard is considering a similar move. Vanguard also has beefed up its bank lines of credit, which would give it a temporary source of cash to meet redemptions.

The company also buys stock-market index futures, which can be instantly converted to cash but are designed to mirror the market’s movements. With futures, a fund has what amounts to a cash cushion without sacrificing full market performance.

In a market cataclysm, there’s even another fallback. It isn’t well-known, but the fine print of most stock mutual funds spells out that redemptions don’t have to be in cash but can be “in kind.”

In other words, if a fund finds itself unable to lay its hands on enough cash to meet redemptions, it may turn over actual shares of stock to investors.

That would be a complicated and unpopular process--one that has never been resorted to in industry history, according to experts--but it passes legal muster.

After Vanguard was burned in the ’87 crash by the inability to get trades executed, “it became apparent that we had to develop extremely deep ties to our brokers,” said Gus Sauter, head of Vanguard’s vaunted index-fund group.

Vanguard now does 75% to 80% of its trading with just five big Wall Street firms. In return, Vanguard expects lots of service.

“If we find a broker is not meeting our needs, we’ll find another lead broker,” Sauter said. “That was our biggest problem in ’87. We feel comfortable now we’ll get the attention we need.”

Ready for Anything

Not all the problems Vanguard has tried to anticipate are related to market shocks.

For example, the company has contracted with Chester County’s largest oil dealers to put itself first in line for diesel fuel in case a blizzard, hurricane or other physical event knocks out power and forces Vanguard to switch to its five huge diesel generators for backup.

That secures the power supply for the firm’s computers, heat and lighting, but what if a winter storm prevented employees from even getting to work?

Vanguard’s answer: geographic diversity. It opened its office in Phoenix four years ago partly to show the flag in a fast-growing part of the country, but also to ensure that no weather mishap could shut its doors.

Now when customers call Vanguard, they’re just as likely to reach a phone rep in Arizona as one in Pennsylvania. Another new location is about to open in Charlotte, N.C.

“In the blizzard of ‘96, eastern Pennsylvania was closed,” Brennan said. “But we called Phoenix and got everybody in at 5 a.m. so we could open the phones here normally.”

The data center “hot site” is another precaution. It can serve as a temporary work location not only in a market crash but also in more mundane emergencies such as a water main break at headquarters.

The downside? The cost, Brennan said, noting: “The hot site drives me crazy because it’s empty most of the time.”