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Home / Special Report / Popular as they may be,
mutual funds not flawless

Popular as they may be,
mutual funds not flawless

Many thought last year was the peak of the bull market. But with the recent strong economic indicators and few signs of inflation, stocks continue to rise. So, too, do the popularity and number of mutual funds.
And for good reason, financial advisers say. Mutual funds offer an investor a great deal of diversification for a relatively small amount of grunt work. They are easy to understand, buy and sell. And with the proliferation of funds–especially no-loads–there certainly are plenty to choose from.
“Mutual funds for the average individual (are) a very excellent (way) to save,” says Anthony Gugino of AM&M Planners Inc. But Gugino also points out that no investment is without risk–even the supposedly “hottest funds” that adorn the covers of popular periodicals such as Money magazine.
“Unfortunately, many people think Money magazine is the Bible,” Gugino notes. But no matter how hot or how popular a mutual fund, or how bullish the market, money managers “don’t have a crystal ball.”
In other words, there are situations in which a mutual fund might not be an investor’s best bet.
One of the most common warnings advisers give is that investors should, from the beginning, be aware of the fund’s objectives and the manager’s style of investing. If the two diverge, experts say, that is a red flag. Managers who change their style of investing over a period of time are not unusual, says Gugino: “It happens with a lot of funds.”
There are several reasons why a manager may change his or her style of investing. Some managers change their style to make up for underperformance, becoming more aggressive in the hopes of quick returns. Or the popularity of a fund may actually become its nemesis. For example, in micro- and small-cap funds, as the fund gains more assets and becomes larger, it becomes more difficult for managers to diversify.
Nobody understands the consequences of mismanagement better than Fidelity Investments. The fund giant had one raucous year in 1996 when it reassigned the managers of 34 funds because of criticism that they had strayed off course on their fund’s initial goals. Supposedly conservative funds were taking bigger risks, and blue-chip funds were acquiring more and more smaller companies, reported Business Week.
The magazine reported that Fidelity Asset Manager Fund, a supposedly conservative fund, came under attack after investing in emerging market debt in 1994. The company’s Blue Chip GrowthFund was criticized for forgetting its name when it acquired many mid-cap stocks.
And even Fidelity’s once shining star, the Magellan Fund, took a hard hit when investors withdrew some $4 billion from the $53 billion fund last year. Manager Jeffrey Vinik was replaced by Robert Stansky in June 1996. Vinik was criticized for buying bonds in what was originally a growth fund. Now, Stansky has almost erased all remnants of bonds in Magellan’s portfolio.
Investors should “be careful if the investment objective of a mutual fund is not consistent,” says Jack Anderson, executive vice president at Howe & Rusling Inc.
Understanding what any investment has to offer and how it fits an individual’s goals is one of the basics, experts say. For example, one of the factors an investor should consider when deciding whether to purchase a fund is how much money she has. If she has more than $250,000, an individual portfolio would be more appropriate, Anderson recommends. That way she would be able to tailor it to her specific investment objectives. This allows a person diversification as well as more flexibility and control.
Also, if a person knows she will be needing cash in six months, a mutual fund would not be the most flexible option, says Anderson. Whether deciding to buy or sell a mutual fund, an investor needs to assess what her personal-investment needs are. For example, putting money away for college and retirement would require different types of funds according to the appropriate risk level.
Another factor investors should consider is the distribution dates of mutual funds. By avoiding buying a mutual fund before a dividend or capital-gains distribution, one may save a considerable amount in taxes, Anderson says. Even though an investor may increase her security assets from the gains, most of them are reinvested back into the fund. But you still have to pay the tax.
The rise of the mutual fund however, is not an anomaly, says Ronald Fielding, senior vice president at OppenheimerFunds Inc.-Rochester Division. When he started in the business some 15 years ago, there was maybe $100 billion invested in mutual funds, he notes. Today the number is up to almost $4 trillion. The reason, Fielding says, is cost.
What happened, he says, is that mutual funds consumed the share of the investment market that used to be peddled by banks and life-insurance companies. The mutual-fund industry has significantly lower costs compared with the very high overhead structure of savings and commercial banks, says Fielding. And even though banks today hold a bigger piece of the pie, Fielding believes in 20 years the mutual-fund industry will be twice as big as the banks.
Besides being more cost-effective, mutual funds have earned a high reputation as a low-fraud industry, Fielding notes: “The mutual-fund industry in the past 50 years is very spotless compared to other investment mediums.”
“There is really government regulation and self-regulation (within the industry),” adds Fielding, a board member of the Investment Company Institute, a mutual-fund trade organization.
However, not all investment advisers forecast that the growth spurt of individual fund companies will continue. Says AM&M’s Gugino: “I believe you’re going to see a consolidation in the industry.”
But most managers agree that just as the market goes in cycles, investment mediums and styles also have their own fashion course. The buzzwords at today’s cocktail parties are equity investments, Anderson remarks. But he also remembers the hot topic of the past: real estate and natural resources.
“It is always scary when people talk about an investment as a sure thing.”

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