Investors find refuge in cash

January 03, 1995|By New York Times News Service

Call it ugly.

For mutual funds, 1994 was ugly in terms of performance -- most stock and bond investors lost money. And, from the industry's viewpoint, it was ugly as one scandal followed another and even uglier as the cascading cash inflows of the previous year began to falter.

But 1994's tough market was bound to come along sooner or later, and it pulled lofty valuations down to more reasonable levels. Investors are well-advised to adjust expectations; the incredible bull-market returns many have come to consider usual are over, at least for now.

But despite a number of industry embarrassments, ranging from loses in government bond funds created by investments in derivative securities to Fidelity Investments' mispricing of its funds' shares, "no issue affected a majority or even a vast minority of funds," said John Rekenthaler, editor of Morningstar Mutual Funds newsletter in Chicago.

So how did cash manage to beat stocks and bonds in 1994? The biggest culprit was the Federal Reserve, which pushed up interest rates six times since February. Higher interest rates play havoc with bond prices, and Treasury bond funds, often viewed as a safe haven, lost more than 4 percent of their value, on average, because they tend to own longer-term issues, which react most violently to shifts in interest rates.

Not that other bondholders had much to brag about. Among taxable bonds, corporate bond funds lost 3.7 percent -- their first loss in more than 20 years. Junk bonds lost almost 5 percent.

Municipal bond funds did even worse, losing about 6 percent. Funds owning mortgage-backed securities were down 4 percent. True to their charter, adjustable-rate mortgage funds were the group's best performers, down slightly more than 2 percent. Among equities, the diversified funds were losers, down 3 percent on average.

The two winning categories of funds invested in small sectors of the market, with technology funds up 9.6 percent and health care funds up almost 3 percent.

Funds investing in European stocks managed to break even. But funds in Pacific Rim stocks were the year's biggest losers, down more than 10 percent on average.

As for bad news in the industry, last year started with the Invesco Group of Denver dismissing John Kaweske, a fund manager, after accusing him of not complying with rules on personal trading. That led to a study by the Securities and Exchange Commission, which concluded that there were few personal-trading cases in the industry.

Then there were spectacular blowups in government bond funds that owned derivative securities.

Shareholders in Paine Webber's Short-Term U.S. Government Income Fund were reimbursed by the company for loss, an acknowledgment that funds sold as conservative should manage their portfolios that way, Mr. Rekenthaler said.

Derivatives are a continuing problem, he added, as evidenced by thefact that some funds hold issues of Orange County, Calif., which has declared bankruptcy.

In the fall, a bank-run money fund finally "broke a buck" -- falling below $1 a share -- the first in the industry to do so and a keen reminder that money funds are not insured by the government. The lesson for investors: Be informed and wary, Mr. Rekenthaler said. Watch out for yields that look too good to be true because they probably are.

From the industry's perspective, cash flow into bond and fixed-income funds has been fairly light. The funds grew by an estimated $25 billion in 1994, compared with $145 billion in 1993, said Dean P. Eberling, first vice president specializing in financial services at Prudential Securities Inc. in New York.

On the other hand, redemptions have been light, too, after peaking in March. "Considering the severity of the bond market declines, it's surprising that the retail investor has been so calm," Mr. Eberling said.

Over all, net new sales of stock and bond funds should total roughly $150 billion last year, compared with $280 billion in 1993 and $197 billion in 1992, he said.

Mr. Eberling said that, scandals aside, the most important event for the industry in 1994 was the flattening of the yield curve in December.

When the spread in yields between short- and long-term issues narrows, people tend to keep their money in money market funds or short-term investments. Growth in the fund industry in 1995 "will come from short- and intermediate-term products," he said, while growth in equities and long-term bonds could slip below 1991 levels.

The fund industry "is still in a position to become the dominant intermediary of the wealth-creation process in the U.S.," Mr. Eberling said. And that could be helped by a comeback of individual retirement accounts -- "which won't affect 1995 but could be a psychological plus for stocks in 1996," he said.

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