In seeking out a fund to buy, try to avoid the wrong moves

Dollars & Sense

September 16, 2001|By Russel Kinnel | Russel Kinnel,MORNINGSTAR.COM

What the heck was I thinking? At the beginning of 2001, I wrote about three funds that might do well if technology rebounded. I can live with the fact that tech didn't rebound; I'm focused on the long term. However, one of my three candidates was just a bad idea: I mentioned Putnam OTC Emerging Growth because it had been clocked in 2000, yet still had all the great resources of Putnam to draw upon.

My mistake was betting on a fund-restructuring project way too early in the game. If you're used to picking stock-turnaround candidates, you might make the same mistake. The crucial difference is that a stock price reflects the market's view for the company's value one, two or even 10 years into the future.

If Jack Welch of General Electric fame were named chief executive of a struggling company today, the stock would rally based on the expectations long before tangible evidence of a turnaround had materialized. Conversely, if multibillionaire investor Warren Buffett were named manager of a struggling fund today, the net asset value wouldn't budge - it simply reflects the market value of the underlying securities. Thus, you'd have plenty of time to buy in. Here are two basic scenarios and when you should bet on each:

New management. The key issue is whether everything is in place or if it's a gradual rebuilding process. When a fund company replaces one subadviser with another, you get the benefit of a stable management team that has already been executing the same strategy for many years. If that's the case, you can jump in almost immediately if you have a high confidence level. For example, when Vanguard replaced Husic Capital with the PrimeCap team at Vanguard Capital Opportunity, it was clearly a good bet right away. In a similar vein, a fund company might switch a fund to a successful manager in the same shop. Bill Nygren taking the reins at Oakmark Fund is a case in point.

However, the no-brainers are few and far between. More often, you get a new subadviser without a mutual fund record or a mixed record. If the new manager is from the same shop, you'll probably get someone with little or no track record. What's worse is that the new manager might have been part of the team that got the fund into its current mess. In these cases, you'll want to wait a few months to see how the manager has remade the fund. Even then, you can probably find something more attractive. Lots of funds have good records and long-serving managers, so why gamble?

No matter how good the new manager is, he or she might dump some long-held stocks in the fund and make a capital-gains distribution. If you're considering a fund that has had a manager change in recent months, don't buy until the next year - unless the fund company is providing an estimate of expected cap-gains distributions.

New strategy - old management. My thinking with Putnam OTC was that Putnam has the resources and the will to fix what's wrong with a fund. If the manager is at fault, they'll replace her and if the strategy is flawed, they'll gut it. The catch is that Putnam is a deliberate shop that doesn't rush into anything. They wanted this fund to be extremely aggressive, so it took a long time for them to decide it was a problem. They've announced plans to rein in risk, but there's no point in being early. Like a company that's restructuring, a fund is likely to have spotty results until the overhaul is complete. Since you don't get the early payoff you do with a stock, there's no need to rush.

Then, does the manager have a great long-term record that inspires tremendous confidence? If not, stay away until the dust settles.

And, take a look and see if the fund has tweaked its strategy in the past. Lots of funds have gone through frequent strategy changes to no avail. Avoid them.

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