For Some, Market Rebound of ’03 Was No Saving Grace

Roy Weitz views the last few years as the ultimate mutual fund petri dish -- a good experiment for determining a fund’s mettle.

But the results of that experiment, he says, may be enough to make some investors reach for the disinfectant.

The Tarzana resident has operated a website called FundAlarm.com since 1996. An accountant by training, Weitz has worked his way into the role of an independent watchdog of the $7-trillion fund industry.

The main attraction on his site: a list of “three-alarm” stock funds -- those that have underperformed their respective benchmark indexes for the previous 12 months, three years and five years.

The three-alarm tally currently lists 886 funds, or about 22% of the universe he surveys. A fund’s presence on the list generally means it fell more than its benchmark during the long bear market and rose less than the benchmark in the powerful market rebound of the last year.

If that kind of sustained laggard performance isn’t enough to cause an investor to at least think about selling a fund, perhaps nothing will, Weitz figures.

“If not now, when?” he asks.

The first few months of each year often give investors their best window of opportunity for a portfolio housecleaning. The annual tax-filing process can force the issue. Plus, the start of a new year always brings hope of better investment returns.

This year, in the wake of the mutual fund industry trading scandal and with the suddenly intense focus on fund management fees, a portfolio review has never been more crucial, many financial advisors say.

Here’s a how-to for determining whether a particular fund might be ripe for jettisoning:

* Start with performance. The annual fund performance tables in today’s Business section show how 5,400 stock and bond mutual funds fared in the fourth quarter, 2003 and the last three years.

Also in this section are average returns by fund category for each of those periods, as compiled by fund tracker Morningstar Inc. in Chicago. There are nearly three dozen stock-fund categories, for example, from very popular types such as “large-capitalization growth” to relatively tiny categories such as Latin American funds.

A quick check of your funds and their category averages will show whether a fund beat or lagged behind the typical fund with a similar investment focus.

Any fund can have a subpar year; that isn’t unusual and isn’t a reason to sell, most financial pros say. But if a fund has consistently lagged behind its peer average in recent years, “You have to at least ask yourself why that is,” says Emily Hall, senior fund analyst at Morningstar.

“And is it something the fund is addressing, or is it mired in mediocrity?” she asks.

In 2003, 55% of funds performed below their category average, the highest percentage since 1999, according to Morningstar.

Of course, a mathematical average can be skewed by the outliers -- a handful of funds that perform very well or very poorly. Still, a fund whose performance has been well below its category average for an extended period ought to be red-flagged, experts say.

On Weitz’s website, stock funds are compared with broader indexes of their sectors.

A fund’s presence on the three-alarm list isn’t an automatic sell signal, Weitz says. Investors should consider a number of factors, he says, including whether a new manager has recently taken over the portfolio, and how volatile the fund has been (i.e., its performance may be modest because it’s taking lower risks compared with its peers, which may appeal to some investors).

But Weitz and other industry experts have long been puzzled why investors stay in poorly performing funds when there are so many better alternatives available.

With his website, offered free to users, the 52-year-old Weitz may be helping to wear down some of the inertia that keeps investors from switching funds.

Weitz, whose day job is accounting management for a not-for-profit organization in Los Angeles (the organization doesn’t allow him to use its name, though it’s fully aware of his website, he says), has been investing his own money in funds for 25 years. He launched Fund- Alarm.com as a hobby, he says, to provide an independent voice on the industry and to have a little fun in the process.

He often takes a humorous tone in his commentaries on industry practices; he has been using a “jail-o-meter” to suggest how close some fund executives may be to incarceration for alleged abuses in the trading scandal.

Weitz says the website costs about $10,000 a year to operate, and that that’s also about what he receives in annual contributions from investors who have used the site.

Some people who send him checks say, “I’ve been following you for years, I just thought I’d pay you back,” he says.

* Look at your overall portfolio mix. The decision of whether to dump a fund may hinge in part on whether it still plays an important and necessary role in your asset mix, financial advisors say.

Even if a fund’s recent performance has been strong, or at least average, it may no longer be appropriate for your portfolio if your long-term financial goals have changed.

Investors who owned high-risk, highly volatile funds through the recent bear market, for example, may find that they would be more comfortable with a portfolio of less-volatile funds. Simply holding on to the high-risk funds because they rebounded in 2003 may not be a smart idea.

Emerson Fersch, a principal at financial planning firm Capital Investment Advisers in Long Beach, says he begins the planning process for a client by determining what the person needs to earn over the long run to meet his or her goals.

For some clients, he says, an annualized portfolio return of 6% or 7% may be plenty to get them where they want to be.

In that case, his answer when it comes to holding certain mutual funds is “you don’t need that kind of risk,” says Fersch, whose favorite fund family is the Los Angeles-based American Funds group.

Many financial advisors say fund owners should consider “rebalancing” their portfolios once a year. That may entail selling shares in some categories of funds to buy others, to keep the asset mix in accord with the investor’s goals and risk tolerance.

For example, investors who want a faster-growing portfolio over time may find that they should be adding to “growth” stock funds this year, particularly if they have been heavily invested in conservative “value”-oriented funds in recent years.

The key is to maintain healthy diversification, Fersch says. Some investors learned the hard way that being overly invested in some types of funds -- such as technology funds in 1999 and early 2000 -- can lead to disaster.

After the bear market, Fersch says, “People are a lot more receptive to the idea of diversification.”

One issue for investors who own funds in tax-deferred accounts, such as 401(k) retirement plans, is whether some new options have been added to their plans in recent years that could help increase their diversification level.

Switching funds in tax-deferred accounts has the advantage that an investor won’t incur a taxable capital gain. But even in cases where a fund is owned in a taxable account, and where a sale would result in a taxable gain, most advisors tell clients to view the tax hit as secondary to the bigger issue of having the proper portfolio mix.

* Consider the effect of the fund industry scandal. More than a dozen mutual fund companies have been implicated in the scandal that first made headlines in early September.

Most of the allegations center on “market timing” of funds, in which some fund firms in recent years allowed favored clients, or company insiders, to make rapid-fire transactions in some portfolios to take advantage of market swings or temporary market pricing inefficiencies.

Timing isn’t necessarily illegal, but it can cost buy-and-hold investors money over time by effectively “skimming” short-term returns and by raising portfolio costs. A fund company can be charged with fraud if it publicly says it discourages timing, yet allows certain clients to engage in it.

So far, few fund companies have formally been charged with wrongdoing. But the firms that have been implicated include some of the industry’s best-known names, including Putnam Investments, Strong Capital Management and Janus Capital.

Should you automatically dump a fund offered by any company that has been implicated in any way? Weitz doesn’t think so. He advises investors to go to their fund companies’ websites and read what the firms say about any allegations against them, and any steps they’ve taken to make sure their funds aren’t victimized by timers.

“Some companies have done the mea culpa, taken responsibility” and are making amends to investors, he says. “Others are stonewalling.”

But Morningstar’s Hall says her firm has taken a mostly critical view of implicated fund companies.

“We’re not clear on how individual shareholders were hurt” by the scandal, she says. But it’s one indication “of how companies treat their smaller shareholders.”

The scandal has had a major silver lining, experts say: It has finally gotten many investors to focus on the issue of fund costs, including management fees.

Every investor ought to know what level of management fees they’re paying to a fund. Those costs come directly out of portfolio assets each year. The fees are disclosed as the “expense ratio” in fund prospectuses and other literature from fund companies.

As a starting point for judging the fairness of fund fees, investors should compare a fund’s expense ratio with the Morningstar category averages listed on this page. (Fund fee information also is available on Morningstar’s website, www.morningstar.com, and at FundAlarm.com, among other sites.)

“Expenses are one of the best long-term predictors of fund returns,” Hall says. More often than not, high-cost funds have sub-par long-term returns.

Hall, Weitz and other experts say they understand that investors find it tedious to do their homework on fund fees. But the long-term payoff could be considerable, they say. “I’m always amazed at people who will line up for gasoline that’s 5 cents cheaper a gallon,” Weitz says, “and yet they won’t look at their mutual funds’ expense ratios.”