Try to learn what makes your fund tick

Mutual funds


The woman at the investment seminar wanted to diversify because she owned only two mutual funds. So she bought a third.

Problem was, she owned Fidelity Magellan and Twentieth Century Ultra, two funds with 40-50 percent of their portfolios in technology stocks at the time. The fund she bought? Seligman Communications and Information, a sector fund that concentrates its investments on more technology.

And then there was the man who wanted to put more money into emerging markets, more than the 10 percent of his portfolio he had in the Montgomery Emerging Markets fund.

What he didn't know was that some of his other funds -- Acorn International, Fidelity Asset Manager and IDS Managed Retirement -- had a portion of their assets in emerging markets. As a result, 25 percent of his money, not 10, was already invested there.

"Thinking you have 10 percent when in reality you have 25 is a prescription for disaster," said Don Phillips, president of Morningstar, a closely followed mutual fund analysis and rating service based in Chicago, as he cited the examples of these two investors.

"The fun thing about funds is tearing apart the portfolio," said Mr. Phillips. "The opportunity is there to tear apart funds and invest in them more intelligently than we have been doing."

Largely responsible for that opportunity is Morningstar, "unquestionably the Rolls-Royce in the mutual fund investment information field," said Harold Evensky, a fee-only financial planner. Morningstar provides, both in print and computer disk, detailed information on funds, including performance history, portfolio and risk analysis, investment style and a host of other statistical data, plus an analyst's commentary.

"Ten years ago the challenge was how to find information," said Mr. Phillips, 33, who has been investing in mutual funds since he was 13. "Today is how to make sense of an overload of information. Now you have to get under the hood and see what makes the fund tick."

To get under the hood, investors need to get past the advertising and marketing hype, and even the star rating Morningstar assigns to each fund it covers. Ratings range from a low of one to a high of five stars, based on a combination of performance and risk for three-, five- and 10-year periods, as well as an overall rating that gives greater weight to the longer-term performance.

"Fund companies seem obsessed with this," Mr. Phillips said. But investors should understand that the star rating "puts a grade on past performance and offers an introduction, not a conclusion."

The basic question, Mr. Phillips said, is not "what fund do I buy now?" but "How do I make sense of the ones I have?"

In other words, investors need to make sure their holdings are diversified not only among asset classes -- stocks vs. bonds, foreign vs. domestic, for instance -- but also among investment styles, such as value and growth.

"You can aim for one target and end up with another," Mr. Phillips said. For example, Fidelity Capital Appreciation, classified as a domestic growth fund, had more money invested in foreign securities 1 1/2 years ago than Janus Worldwide, a global fund that also invests in the United States.

Investors also need to know not just how their funds have performed but why, Mr. Phillips said. Just about all the top stock funds over the past five years, for example, have been "overweighted" in technology, a strong performing area. That is, technology stocks made up a greater percentage of the assets of these funds than they do of the overall market.

"There is nothing wrong with taking those positions if you are cognizant of it," Mr. Phillips said. The other side of the coin is that technology stocks can be quite risky, as evidenced by double-digit losses in many tech-laden funds in the past few weeks.

One problem in evaluating performance is that there hasn't been a drop of 10 percent or more in the overall market in more than five years. Therefore, five-year return figures for most stock funds are quite impressive.

"Now we are looking at a tremendously favorable time period," Mr. Phillips said, and the funds' marketing departments are not about to let the opportunity go to waste. But, Phillips said, "No one took an ad after the crash of 1987 saying, 'Look at how much money we lost for you last month.' "

Investors, however, cannot ignore risk, and the shorter their investment time horizon, the more they need to focus on it, Mr. Phillips said. He suggests you find the worst return of a fund over a three-month period, and ask yourself how you would react if you suffered such a loss with a "meaningful amount" of your money.

"If you would have panicked and fled, then it's not the right fund for you," he said.

If you are still tempted to invest in such a fund because of its long-term record, Mr. Phillips recommends you do so by dollar-cost averaging, that is, by putting in a little at a time rather than a big sum all at once that could expose you to a big loss in a down year.

In fact, "Avoiding those terrible years is often the key to success," said Mr. Phillips. For instance, Twentieth Century Growth Investors sported the largest single-year gain, 69 percent in 1991, but it suffered losses in 1990, 1992 and 1994, while Third Avenue Value lost money only in 1994. "I think Third Avenue Value will probably make more money for people," he said.

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