Are Growth Funds Playing It Too Safe?

On the radio show “A Prairie Home Companion,” host Garrison Keillor likes to say of fictional Lake Wobegon, Minn., that all the children are above average.

In the stock mutual fund industry, some portfolio managers scarred by the long bear market appear to be aiming for the same goal, but with a questionable strategy, according to Morningstar Inc. analyst Brian Portnoy: They’re trying to beat the investment crowd, but not necessarily by much -- while playing it relatively safe to minimize the odds of bombing out.

Portnoy has a message for them: “This isn’t Lake Wobegon. Somebody’s got to be below average.”

Moreover, a strategy of playing it safer may be less likely to produce the desired above-average results, at least if the market is headed higher, analysts say.

After three years of pain, some managers are turning into what Portnoy labels “index huggers” because their stock holdings and industry sector weightings hew closely to their benchmark indexes. The breed appears to be common in the growth fund category, where bear market losses were the most severe.

The message for growth-fund investors is to look carefully at your fund to make sure the manager’s strategy fits your goals and risk tolerance, experts say.

“The bear market has structurally encouraged the industry to take less risk,” Portnoy said. “Large fund companies with tens of billions of dollars under management don’t want to mess up anymore, so they’ve designed parameters that don’t allow managers to stray too far from their benchmarks.”

As a result, many growth managers have scaled back their bets in the volatile technology stock sector and diversified by adding more health care and other holdings. It’s a strategy that could lead to smoother long-term performance, but in many cases may have backfired in the first half.

“Investors, whether professional or individual, have a tendency to respond to what recently happened, and there is a very long, deep scar from the tech collapse,” said Don Cassidy, analyst at Lipper Inc. in Denver. “For money managers, it’s a matter of not walking down the same side of the street where the dog bit you.”

Getting more conservative has not necessarily paid off, however. Though most growth funds notched gains through June 30, the majority lagged behind their benchmark Frank Russell Co. stock index, according to Morningstar data.

Of the 2,645 actively managed growth funds in the Morningstar database, only 789, or 30%, beat the corresponding Russell large-, mid- or small-cap growth index in the first half. Of large-cap growth funds, 36.5% beat the index, while 24.1% of mid-cap and 23.5% of small-cap growth funds did the trick.

The average large-cap growth fund gained 12.7% in the half, compared with 13.1% for the Russell 1,000 growth stock index; the average mid-cap growth fund rose 15.9%, versus 18.7% for the Russell mid-cap growth index; and the average small-cap growth fund climbed 17.1%, against 19.3% for the Russell 2,000 growth index.

“In behavioral psychology they call it loss aversion,” Portnoy said. “You want to avoid the fourth quartile at all costs, but as a result you make it impossible to finish in the first quartile.”

He noted that in the late 1990s, the Janus funds thrived by making risky but successful sector bets on technology, telecommunications and media. The bets were costly, however, after the market turned in 2000.

Denver-based Janus Capital Group Inc. has toned down its sector bets in the last year, analysts note. David Corkins, respected manager of the relatively conservative Janus Growth & Income fund, recently took the helm at Janus Mercury, which sports an annualized three-year loss of 23% through the second quarter of this year

Boston-based Putnam Investments continues to shuffle its fund management teams, hoping to find the right mix. Last week, the Boston-based firm announced manager changes at four of its growth funds: Voyager, Vista, Growth Opportunities and OTC & Emerging Growth. All four suffered annualized losses of 20% or more over the last three years.

Roy Weitz, editor of the Los Angeles-based Web site FundAlarm.com and a self-appointed critic of the fund industry, notes that many of the Janus and Putnam funds “are clustered around the middle of their peer group” in terms of this year’s performance.

“My guess is that’s exactly what they’re shooting for,” Weitz said. “Janus and other fund companies that have been burned are kind of like the driver who keeps pace with traffic so the cop doesn’t pick them out for a speeding ticket.”

Of course, the changes could pay off for Janus and Putnam in the long haul, depending on how the market performs.

The growth funds run by Turner Investment Partners Inc., in contrast to some firms, have kept the pedal to the metal and reaped the benefit, Weitz said. Turner Midcap Growth, for example, surged 20.7% in the first half, handily beating its peer group average.

Many growth managers with stellar relative returns in the first half, such as Baron iOpportunity’s Mitch Rubin and Oberweis Emerging Growth’s James W. Oberweis, say they are succeeding by sticking to their aggressive guns -- focusing on company fundamentals without worrying about benchmarks or the investment crowd.

“A lot of people get caught up in market timing and trying to beat the indexes, but we’re just looking for great companies and management teams,” said Rubin, whose fund holds big-name Internet stocks like EBay Inc. as well as names he believes are benefiting from the Net and technology “revolution” such as game maker Electronic Arts Inc. and photo supplier Getty Images Inc. The fund jumped 37.5% in the first half.

“If you have to worry, ‘I’ve got to beat my benchmark,’ that’s not a rational way to invest,” said Rubin, whose fund was launched in early 2000.

Oberweis, who also runs Oberweis Midcap and Oberweis Micro-Cap, said he hasn’t changed his stripes, either. Midcap and Micro-Cap gained 26.2% and 45.7% in the first half, respectively, while Emerging Growth rose 29.9%. Although market bears say speculators are running again, Oberweis said his gains reflect a more rational stock market.

“During the late ‘90s it was a great market for large companies, and valuations weren’t important,” Oberweis said. “What a different world we live in today. Valuations matter again, even when it comes to growth stocks.”

He said several factors have come together to create “the perfect storm” for his funds: “Coming out of recessions, smaller stocks tend to do well as the appetite for risk improves. Investors are still conservative these days, but less so than they were three months ago.”

Despite their aggressiveness and independence, Rubin and Oberweis say they, too, take steps to rein in risk.

Though Oberweis looks for companies with rapidly growing earnings, he will only buy them if he believes valuations such as price-to-earnings ratios are reasonable relative to the company’s growth prospects.

His funds’ holdings include OmniVision Technologies Inc., which makes chips for digital cameras used in cell phones, and Able Laboratories Inc., which makes generic drugs aimed at “niche markets.”

Rubin acknowledges that many of his holdings, like EBay, command premium valuations. “There really are two risks: execution and valuation,” he said. “These companies face new competition all the time, so they can always stumble, and they may have far to fall.”

But Rubin said he tries to limit the downside by searching out strong management teams and companies with solid balance sheets and expanding profit margins.

For their part, some managers of lagging growth funds say they only appear more conservative.

“We really haven’t pulled in our horns,” said Art Bonnel, whose USGI Accolade Bonnel Growth fund rose 3% in the first half. “Back in the ‘90s, when companies were recording triple-digit earnings growth, we paid high-double-digit P/Es. Now the companies we’re in look more conservative, but it’s more a reflection of the economy.”

Because tech stocks “aren’t showing prodigious earnings gains” these days, Bonnel said, the screens he uses to find prospects have led him to shift more assets into health-care stocks.

Lagging managers try to put the best face on their modest gains.

“At least things are positive,” Bonnel said. “That’s better than the last three years.”