Why Some Funds Decline as Steeply as They Rise

At first blush, the worst-performing diversified stock funds during the recent market slide would seem to have little in common.

Neuberger & Berman Guardian, for instance, which is off 30.4% since the market peaked on July 17, is a large-cap value fund. Rydex Nova, which is down 26.6%, is an aggressive growth portfolio. And American Heritage, which has lost a stunning 47.4% during this two-month stretch, invests in small companies.

But talk to the managers of these portfolios--and the others that made the list of the 25 worst performing large-cap and small-cap funds from July 17 to Sept. 10--and certain themes surface.

"The commonality is real simple," said Sheldon Jacobs, editor of the No-Load Fund Investor newsletter. "It's what they're invested in."

Some fund managers are quick to note that their poor showings are to be expected.

Their message to investors: You can't criticize us for doing what we said we would.

Rydex Nova, for instance, is not only supposed to perform in sync with the benchmark Standard & Poor's 500 index of blue chip stocks, the $805-million fund is designed to magnify that performance by 50%. Hence, when the S&P; 500 fell 17.2% from July 17 to Sept. 10, Nova fell 26.6%.

Similar arguments can be made for Potomac U.S. Plus and ProFunds UltraBull. ProFunds UltraOTC was hurt by recent sell-offs in large Nasdaq stocks like Dell Computer, but for the year to date, the $55-million fund has feasted on such large growth stocks, delivering returns of 39.8%.

Financial planners note that since investors use the above funds not as core holdings but to boost returns, short-term losses may not be so troubling.

Indeed, investors may want to buy or sell these funds not solely on short-term performance, but based on their own sense of how the market or a particular sector is likely to do going forward.

Bad Bets

Among the most common explanations given for poor performance--especially among value managers, who seek stocks considered undervalued compared with the company's earnings, assets, or intrinsic value--is a bad bet made on a particular industry or sector.

Prior to the market correction, many sectors were considered so pricey that many managers scavenged energy and financial stocks, two sectors with low price-to-earnings ratios. But these sectors have been battered further.

"A couple of our areas got hit harder than the market in general," said Jim Oelschlager, manager of the $672-million White Oak Growth Stock fund, which had been white-hot coming into 1998, posting total returns of 52.7%, 32.3% and 24.3% in the previous three calendar years.

"One of the areas, financials, saw stocks like Citicorp get cut almost in half," Oelschlager said. "Clearly, this is overdone and unjustified."

Vanguard/Windsor, once a well-regarded fund delivering 20%-plus returns, also recently fell off its pedestal thanks to its quarter-stake in financials. Since the market top, Windsor has lost 24.9%.

Investors in such funds must weigh a fund's short-term stumble against its long-term performance, financial planners say. Indeed, T. Rowe Price Associates financial planner Christine Fahlund says investors must still consider a fund's three-year, if not its five-year track record--provided it the same fund manager has been in charge.

For instance, both White Oak Growth and Steadman American Industry are off about 30% since the market peak of July 17. Yet, White Oak Growth has still managed to deliver 22.3% a year for the last five years. Steadman, by contrast, has lost about 14.8% a year during that time.

Too Much Focus

Many managers say their funds were not only hurt because of their position in financial stocks, but because the portfolios are "concentrated."

Focused funds have become all the rage in the fund industry, which is constantly seeking ways to make portfolios stand out in an increasingly crowded field. A focused portfolio invests not in 100 or more stocks, as in common in the industry, but in 20 or 30 of the manager's so-called "top picks."

In theory, this makes sense. If the picks are on the money, these actively managed portfolios should greatly outperform in down markets. However, if even a handful of a focused fund manager's holdings trip, the fund could easily find itself trailing the market.

Consider what's become of the popular Torray fund.

This $1.5-billion fund, which has advanced 20.8% a year for the past three years, has lost 25.3% in the recent market slide.

"It goes with the territory," said Bob Torray, who co-manages the fund, whose top 15 holdings constitute roughly 75% of the fund's assets. "When you run a concentrated fund and you run into a situation like this, it's always possible that a third or even a half of your stocks will be hit all at one time."

In addition to his large stake in financials, Torray notes that many of his satellite-related firms, such as Hughes Electronics and Loral, have also plummeted.

Yet Torray, whose fund boasts a low annual turnover rate of just 12%, isn't selling.

Another example of a stellar concentrated fund gone bad in recent weeks is Neuberger & Berman Focus.

This $1.5-billion fund not only concentrates its investments in six sectors, it entered the market slide with more than 50% of its assets in just one--financial stocks, led by Chase Manhattan and Travelers Group.

For the last decade, this strategy has worked to the tune of 14.1% annualized returns. But lately, such dependence on financials has crushed the portfolio. Since July 17, Neuberger & Berman Focus is off 32%.1.

"I don't think there was any special event or any one stock that contributed in some significant way to the poor performance," said Dick Cantor, a principal with Neuberger & Berman. "I think the answer is that we're focused."

"We're in financials because we and the portfolio managers regarded it as an inexpensive sector," Cantor said. "And if the portfolio managers thought they were cheap before, I suspect they consider them even more attractive now."

Size Disadvantage

Another reason that Neuberger & Berman Focus and Guardian may have underperformed recently?

In its efforts to seek out undervalued stocks, the portfolio managers have looked at the smaller range of the large-cap stock universe, sometimes straying into mid-cap stocks.

Like many other managers on the worst-performer list who did the same--including Vanguard Windsor--the move proved to be counter-productive in recent weeks.

According to Salomon Smith Barney, the typical mid-cap stock is off 30.5% from its 52-week high. By comparison, the average large-cap stock, with a market capitalization of $20 billion or more, is off just 23.2% from its 52-week highs. (Market cap can be calculated by taking a company's current stock price per share and multiplying it by the number of shares it has outstanding.)

Indeed, the common outcry among the worst-performing small-cap stock managers is that size mattered during the recent market slide. And their funds' adherence to the tiniest of small-cap companies--known as the micro-caps--hindered their performance.

"The way it's been, the smaller the stock, the harder it's been hit," said Dan Perkins, co-manager of the $29.9-million Perkins Opportunity fund. "Our median market cap is under $100 million." (The typical small-cap fund is allowed to invest in stocks with market caps of $1 billion or less.)

Because small-cap stocks are underfollowed by Wall Street, many small-cap funds outperform by getting to know individual companies well. Unfortunately, because of Perkins' small staff, many of the companies it tracks are close to home, in the upper Midwest. And that region tends to be dominated by health-care and technology shares, which have been hit hard in the recent market correction.

Concentration certainly hurt some small cap funds, too.

One can argue, for instance, that American Heritage was hurt by having more than 95% of its assets in its top 10 holdings. Indeed, as recently as the end of April, one stock, Senetek, controlled about two-thirds of the fund's assets;

Other small-cap managers say their short-term performance can be blamed on recent opportunistic steps which will pay off later.

Hotchkis & Wiley Small Cap fund co-manager David Green, for instance, notes that he and co-manager James Miles "buy stress."

That is to say, they look for stocks with solid balance sheets that may have stumbled recently, perhaps missing a quarterly earnings target. Such stocks tend to be overly punished by the market, Green said. "Once the market is done overreacting, we make lots of money for holding these stocks," he said.

However, the strategy has driven the fund's short-term returns down 31.3% since July 17.

Crabbe Huson Special and Crabbe Huson Small Cap have been major disappointments in recent months. Each of the funds is down about 33% since July 17, and Crabbe Huson Special is off nearly 50% over the past 12 months.

"It's been the most stressful period I've ever gone through, at least since 1973-74," said co-manager Jim Crabbe.

He said as much as 80% of this year's losses took place in July and August, and can be blamed on his technology, health-care, and oil or oil services stocks.

But Crabbe said in the vast majority of the stocks he buys, either company insiders or the company itself is buying the company stock--which is a sign of strong balance sheets, insider confidence, and possible share price appreciation.

Thus far in September, Crabbe notes that his fund's contrarian outlook is paying off. Both funds, which invest in small companies, have gained 11% thus far this month.

A problem plaguing many small cap funds is redemptions.

Safeco Small Company Stock No Load, for instance, has seen its net assets go from $23 million in January to $77 million as the market peaked and back down to about $40 million now.

"I could point the finger in a lot of directions, but it ends up coming back to me," said manager Greg Eisen, whose small-cap portfolio had been one of the best performers in its category leading up to July.

Eisen notes that due to redemptions, he may have to sell some of his current holdings if he wants to add stocks to his portfolio, reducing his flexibility.

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Stock Market Barometers

Fundamental and technical indicators of the market's health

Key indexes vs. their 200-day moving averages:

A stock index's 200-day moving average indicates the basic trend, up or down. It is generally bullish if the index stays above the average.

*

Price-to-earnings ratio of Standard & Poor's 500: 22.23*

Based on operating earnings per share, 12 months ended June 30; average since 1923: 13.5

*

Dividend yield of the Standard & Poor's 500: 1.60%

Average dividend yield of blue-chip stocks; avg. since 1923: 4.5%

*

Weekly new highs vs. new lows on the NYSE: 65/738

Data for the week ended Friday. More highs indicate a bullish trend.

*

Investment newsletter sentiment:

Stocks' near-term trend as predicted by 135 independent investment newsletters, weekly survey by Investors Intelligence. The data are often viewed as a contrarian indicator: A rising percentage of bulls can signal a topping market.

Bullish

Sept. 4: 40.7%

Friday: 37.3%

Bearish

Sept. 4: 43.2%

Friday: 46.6%

Correction

Sept. 4: 16.1%

Friday: 16.1%

*

Put-call ratio: 0.57

The ratio of stock put options to call options traded last week on the Chicago Board Options Exchange. Ironically, a low put-call ratio--under 0.40--can be construed as bearish because it indicates a high level of optimism, leaving a lot of room for disappointment.

* Now calculated based on operating earnings, which exclude one-time charges--so P/E is lower than if actual earnings were used.

Source: A.G. Edwards & Sons. More information can be found at

http://www.agedwards.com on the World Wide Web.

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