Some were too timid, others too aggressive, but all watched the bull roar past. To make matters worse, almost all charged high fees.
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Some were too timid, others too aggressive, but all watched the bull roar past. To make matters worse, almost all charged high fees.
Even when you factor in last year's generally disappointing results, the five-year returns of many mutual funds look pretty terrific. But despite the historic bull market we experienced over most of that period, some funds were disasters.
We decided to take a look at a handful of the worst performersnot only because their experiences could prove interesting (albeit in a train-wreck sort of way), but because they might shed light on some key factors that cause mutual funds to underperform. To find funds with the worst five-year records through the end of last year, we searched Morningstar Principia Pro, a CD-ROM program from Chicago-based Morningstar.
After weeding out portfolios with less than $100 million in assets, plus those that required initial deposits of more than $10,000, we came up with the ones we're about to discuss. All but one of them carry sales charges, which range from 3 to 5.75 percent of the amount you invest. These loads served to further erode returns.
In conversations with us, and in their reports to shareholders, fund managers did their best to put a pretty face on the picture. Some highlighted their funds' better recent returns, while others pointed out that some of the bad years had occurred during another manager's tenure. What they couldn't dispute, however, is that over the five years, investors didn't get anything close to their money's worth.
What should you do if you find one of these dogs cowering in your investment kennel? Kick it out. Five years is plenty of time for a mutual fund to prove its mettle, so don't wait for it to rebound.
Can hordes of investors be wrong? Yes, if they're among the tens of thousands who owned the $902 million Merrill Lynch Growth FundClass B. It was pretty hard to lose money in a large-cap growth fund over the past five years, but these folks did, after a 4 percent load, taxes, and inflation took their toll. Merrill Lynch Growth Fund underperformed the Standard & Poor's 500 Stock Index by a whopping 15.2 percentage points annually.
The killer was 1998: Merrill Lynch Growth Fund's energy holdings took big hits, its sizable position in real estate investment trusts remained stagnant, and management held too much cash in a year when the S&P 500 gained more than 28 percent. The fund had also drifted into buying medium-size companies and value stocks. As a result, in 1998 it lost 24.2 percent. A management change soon followed.
"When Steve Silverman took over the fund in 1999, he set about remaking the portfolio," says Merrill Lynch spokesperson Christine Walton. "Now it's truly a growth fund." Recent returns are encouraging: In 1999, Merrill Lynch Growth earned 26.2 percent, and last year it beat its category index by more than 5 percentage points.
The fund's five-year return, however, still suffers the effects of Merrill Lynch's previous management style. For years, its portfolio teams selected stocks without sharing ideas with managers and analysts from other house funds. That was in sharp contrast to how more-successful rivals such as Fidelity and Janus operated.
Merrill Lynch has since wised up and opened the tap on the free flow of ideas; managers of similar funds were moved into neighboring offices, and the number and frequency of meetings were increased. Unfortunately, the company still has a fondness for charging high fees, and that'll continue to hinder its funds' performance.
The new frontier for Seligman Frontier FundClass A ought to be making its shareholders more money: Though it underperformed its index by only a couple of percentage points annually, its 4.5 percent annualized five-year return placed it dead last among the small-cap growth funds we screened. Perhaps that explains why Seligman replaced Arsen Mrakovcic, who'd managed the portfolio since 1995, with Mark J. Cunneen, a 15-year investment veteran and a graduate of the University of Pennsylvania's prestigious Wharton School.
Like many new managers, Cunneen seems eager to distance himself from the fund's past performance. "I can't talk about anything that happened prior to March 1, 2000," he says, referring to the date he assumed control of Seligman Frontier.
Maybe he can't, but we will. Former manager Mrakovcic held a smaller percentage of assets in technology relative to the fund's peers, and owned a bunch of health care services stocks that fell ill. Mrakovcic's conservative bent further eroded returns: It led him to purchase many value stocks during a time when growth was king.
To stanch the bleeding, Cunneen ramped up the number of holdings involved in wireless services and computer software, which increased his tech block to 40 percent. Unlike Mrakovcic, he's bringing a pure growth strategy to the fund and is willing to pay a little more for stocks that he thinks have excellent long-term prospects. Seligman Frontier's lower asset size should allow Cunneen to move nimbly in and out of small stockssomething that becomes difficult when a small-cap fund gets big. "We've got more than $200 million in assets [including all share classes], so we've got a lot of room to play with," he says.
On its face, the 5.2 percent average annual return of Phoenix-Zweig Strategy FundClass A doesn't look horrible. But it surely does when you consider that the typical large-cap value fund averaged almost 14 percent annually over five years, and the cream of the crop earned 20 percent or more. "We've talked with Morningstar about reclassifying the fund as a large-cap blend," says Carlton Neel, who took over as portfolio manager in January 2000. "This isn't the deep, deep value fund that it used to be."
Phoenix-Zweig Strategy Fund is one of six Zweig funds marketed by Phoenix Investment Partners. All of them attempt to bask in the glow of Wall Street veteran Martin Zweig, a regular on Wall $treet Week With Louis Rukeyser. Zweig doesn't pick individual stocks, but he does determine the fund's asset allocation and develops models for stock selection.
According to Morningstar, Phoenix-Zweig Strategy Fund missed the boat because Zweig's models were frequently bearish during the 1990s. As a result, the fund often held big cash positions: 22 percent in 1998, and an incredible 43 percent in 1999. Ya gotta be in it to win it, and Phoenix-Zweig Strategy Fund wasn't in it.
"Marty was being cautious because interest rates were rising, and there was too much optimism in the market," says Neel, who adds that 95 percent of the fund's assets are now invested. "We've been gradually increasing the percentage as the Fed has cut rates and interest rates have declined. The breadth of the market is much better now, and a number of sectors look very attractive to us.
By the time you read this, Kemper Small Cap Value FundClass B may have been merged into one of the funds in the Scudder Investments family. It's just as well. Since its inception a little more than five years ago, this fund gained only a third as much as the typical small-cap value fund.
Although Kemper Small Cap Value's portfolio managers have stayed true to the fund's proclaimed investment style, those who preceded the current manager were slow to move into tech stocks, which made up just 7 percent of assets in 1997 and 1998. The share of tech increased to 21 percent in 1999just in advance of the sector's collapse in early 2000.
Serving as a double whammy, in 2000 Kemper Small Cap Value's industrial cyclical stocks suffered heavy losses. Fortress Group, a home builder that had been the fund's biggest holding, dropped more than 36 percent in price. According to spokesperson Amy Schwabero, Kemper Small Cap Value's sector weightings have been retooled to match those of its category benchmark, the Russell 2000 Value Index, which returned 22.8 percent last year. For instance, technology, which made up 25 percent of the fund's portfolio for much of 2000, is now at 14.4 percent.
The rebalancing could help performance, but the fund has a bigger problem working against it, says one expert. "If you look at the records of funds offered by insurance companies like Kemper or by arms of insurers, they're generally awful," says Roy Weitz, editor of FundAlarm (www.fundalarm.com ), an Internet site that alerts investors to clunker mutual funds. That's true for two reasons, he explains: The companies tend to concentrate more on their underwriting services, and they don't compensate their fund managers as well as firms that focus exclusively on investments.
You wouldn't think our list would include a fund that returned almost 93 percent in 1999. Yet even with that spectacular year, Strong International Stock Fund has eked out just 1 percent annually over five years. "The fund was overly diversified before I joined it," says manager David Lui, who came aboard in May 1998. "It owned more than 170 stocks, which was way too many, in my opinion. The first thing I did was get rid of more than half of them." The fire sale included many small positions that Lui sold at a loss, contributing to a negative total return in 1998. "They were rather illiquid, and it took a while to unload them."
Another problem that contributed to underperformance may have been Strong International's drift from growth to value, which Lui has worked to correct. The fund is now squarely focused on large-cap growth stocks. "Style drift is especially harmful to international funds, because there are already so many variables you have to try to control," says Roy Weitz. "If you start screwing around with style, too, you're going to wind up with a mess."
Morningstar Senior Analyst Kunal Kapoor agrees. "Clearly, the fund needed a new manager before Lui arrived. It was in really poor shape."
Yet it continues to struggle. Strong International Stock lost 36.6 percent last year because it overstayed the tech and telecom party. "I was holding onto my winners from 1999 to ensure that the fund wouldn't make a capital gains distribution in 2000," says Lui, who prides himself on limiting investors' tax exposure. (The fund hasn't made a single capital gains distribution under his stewardship.) "We've since lowered our technology, media, and telecom positions."
Like Strong International, AIM Global Telecom and Technology FundClass B shows how an otherwise lackluster fund can look impressive to an unsophisticated investor. The AIM fund returned 107 percent in 1999phenomenal on an absolute basis, but 9 percentage points less than the return of the PSE (Pacific Stock Exchange) Technology 100 Index, its assigned benchmark in Morningstar. Worse, over five years the fund has underperformed the PSE Tech 100 by more than 20 percentage points annually.
"We use the S&P 500 as a benchmark," AIM spokesperson Ivy McLemore is quick to point out. Although that makes for a much more favorable comparison, the fund lagged the S&P 500, too, by more than 6.5 percentage points a year.
But don't hold AIM entirely responsible, says McLemore: The fund was managed by the former GT Global Funds prior to 1998. "It was strictly a telecom fund when we bought it," he explains. "We've since cut back on both telecom companies and foreign holdings." Indeed, exposure to European companies, which made up more than a third of the portfolio's assets in 1998, measured a paltry 2 percent at one point last year.
Sometimes, like a deli man with a hunk of cheese, a fund family slices its offerings a little too thin. Fidelity Select Medical Delivery Portfolio, which owns stocks of health care services companiesincluding HMOs, hospitals, nursing homes, and pharmacy-benefit managershas underperformed more diversified health care funds by nearly 13 percentage points a year. That even factors in a blockbuster 67.8 percent return in 2000.
In keeping with Fidelity's custom of rotating managers through its smaller funds, Fidelity Select Medical Delivery has had eight managers in 10 years. Nevertheless, the revolving door likely didn't affect returns as much as industry-specific problems did.
"Health care services companies, particularly hospitals and HMOs, were hit badly by the 1997 Balanced Budget Act, which significantly reduced Medicare payments to both entities, biting into profit margins," says Morningstar analyst Valerie Putchaven. "As a result, the fund's three-, five-, and 10-year returns place it consistently in the category's bottom decile. In addition, the fund's narrow mandate has led to sky-high volatility." Not coincidentally, Fidelity's more diversified health care fund, Select Health Care, has enjoyed a 23.2 percent annualized return over five years.
"Medical Delivery is a niche fund," says Johanna Thornblad, a Fidelity Investments spokesperson. "It's for people who are particularly interested in or knowledgeable about this small sector of the health care market, and who want the diversification that a fund can provide. It doesn't invest in biotechnology and pharmaceutical companies like a broader-based health fund."
Putting your money into junk bonds can be as risky as eating spaghetti and meatballs while driving with your knees. Okay, maybe not that risky, but it can be a pretty nail-biting experience when the junk-bond fund you've chosen is Delaware Delchester FundClass B, which had a negative annualized return over five years and underperformed the Credit Suisse High Yield Index by 6.2 percentage points a year.
A scarcity of in-house analysts prior to 2000 hurt the fund's returns the most, says new portfolio manager Peter C. Andersen. His team of high-yield analysts, many of whom moved last year to Delaware Investments from Conseco Capital Management, increases the number from four to 12.
With the Delchester fund in dire straits, the additional hires were essential. Choosing high-yield bonds is becoming more difficult for analysts, because of the sheer number available and variations in quality. Put simply, there's junk, and then there's junk.
"More than ever, bond pickers have to thoroughly understand the technical aspects of each issue, and they need the time to be able to do that," says Andersen, who dumped more than half of the Delchester portfolio soon after his arrival. To ensure that his analysts aren't overstretched, he plans to limit the number of bonds in the portfolio to around 100.
Okay, you've purged your portfolio of rotten mutual funds. Now what? Come tax time, you can deduct your net losses dollar for dollar against your capital gains. But what if your losses exceed your gains? You can deduct the excess, up to $3,000 a year, on Schedule D of your Form 1040. Losses bigger than $3,000 you can carry over to future years.
The $3,000 limit applies to joint returns only. If you and your spouse file separately, each of you can deduct a maximum of $1,500, and you can't deduct each other's losses. Balances over $1,500 must be carried forward.
The rules are a little different when a married person dies: The surviving spouse can claim losses up to $3,000 on the final joint return but can't carry over any remainder. Likewise, an unmarried person's estate can't deduct more than $3,000.
Suppose you sell a mutual fund you lost money on, then later believe it could be poised for a turnaround. You can get back in, but if you don't wait a minimum of 31 days from the date you sold your original shares, you won't be able to deduct your losses.
The following mutual funds, discussed in the accompanying article, finished at or near the bottom of their investment categories, based on five-year returns.
|Category||Benchmark||Load||5-year total annualized return|
|Merrill Lynch||Large-cap growth||Russell Top 200 Growth index||4.00||3.1%||19.0%|
|Seligman Fron||Small-cap growth||Russell 2000 Growth Index||4.75||4.5||7.1|
|Phoenix-Zweig||Large-cap value||Russell Top 200 Value Index||5.75||5.2||17.9|
|Kemper Small Cap||Small-cap value||Russell 2000 Value Index||4.00||5.0||12.6|
|Strong||Foreign stock||Morgan Stanley Capital InternationalEurope, Australasia, and Far East (MSCI-EAFE) Index||None||1.1||7.1|
|AIM Global||Technology||PSE (Pacific Stock Exchange) Technology 100 Index||5.00||11.8||32.2|
|Fidelity Select Med||Health care||Wilshire 5000 Index||3.00||8.4||16.7|
|Delaware||High-yield bond||Credit Suisse High Yield Index||4.00||1.6||4.6|
Dennis Murray. Why mutual funds miss their mark. Medical Economics 2001;7:38.