Math tricks to learn on the road to wealth

Your Funds

Dollars & Sense

November 18, 2001|By CHARLES JAFFE

THE MARKET downturn has lingered for so long that it's now entertaining fund investors with stupid math tricks.

These number oddities are worth learning about because the mathematical vortex of a down-and-volatile market sometimes leads investors into bad decisions.

So, let's examine the disappearing three-year returns trick and the mysterious shrinking assets-growing costs trick.

The disappearing returns problem right now is hitting technology-laden funds the hardest.

For example, consider the Amerindo Technology fund. At the start of September, its three-year performance stood at an average annualized gain of roughly 4.5 percent. Today, the three-year performance is an annualized loss of more than 12.5 percent. That's a 17-point swing in a three-year average in just two months.

Amerindo is far from alone. Fidelity Select Electronics saw its annualized three-year gain shrink from 36.17 percent when measured in September to 19.75 percent now. Hancock Technology saw a three-year gain of 10.2 percent melt to less than 1 percent. And Munder NetNet's three-year returns moved from a positive 3.94 percent in September to a negative 6.6 percent by November.

Those are random examples; there are literally hundreds of funds with returns that seem to be vanishing.

It's not current market conditions that are making this happen, it's fallout from past markets. Three-year returns are calculated using "rolling" time periods, meaning the past 36 months. When October 2001 was complete and in the books, October 1998 fell off the three-year roll.

The fall of 1998 saw stocks rebound sharply from a summer slump. That means this is just the start for wild numbers moves.

Over the coming months - as November 1998 through January 1999 get rolled out of the picture - the three-year numbers on many funds will make the progression from ugly to beastly to ghastly.

That trend will accelerate a year from now, when the bull market of 1999 fades from the three-year numbers.

"Don't make hasty decisions based on these numbers alone," says Roy Weitz, who runs the FundAlarm.com Web site, which uses three-year returns to help determine when to dump an underperforming fund. "Anyone who has volatile funds and who sees big swings in performance should realize that this happens sometimes. It's not good, but it's a part of fund arithmetic."

For investors who see three-year return numbers plummet, here are two things to consider:

1. You most likely are too tech heavy. It's OK to have this experience with one fund or possibly two, but if all of your funds show this trend, you've got too much overlap and too little diversification.

2. Look less at the absolute return numbers and more at performance compared with peers. Funds tend to ride the tide together, which is why this phenomenon is hitting tech-heavy funds simultaneously. If a fund suddenly sports a negative three-year number, see how it rates against its peers; it may still be worth holding - as a good representative of the asset class - even if the raw return numbers are on the decline.(Fidelity Select Electronics, for example, remains near the top of its category; Amerindo ranks near the bottom, according to Morningstar.) Now on to the shrinking asset-growing cost trick.

About half of all stock funds use a sliding scale to calculate expense ratios, with "breakpoints" where costs go down as assets rise. For example, a fund might carry management fees of 1.25 percent on up to $100 million in assets, but 1 percent on assets between $100 million and $500 million. Above that level, the management fee might drop to 0.75 percent.

The result of this scale is that a $1 billion fund might end up with an effective expense ratio - what you actually pay if you're an investor - somewhere in the neighborhood of 1 percent.

But when funds shrink due to losses and redemptions, those breakpoints are crossed in the wrong direction.

If that $1 billion fund shrinks back down to $500 million, the effective expense ratio will rise to about 1.2 percent, meaning you pay more at a time when the fund is doing less. That actually makes a mild case for leading the charge out the door, rather than sticking around and paying more.

But this is not the same as a fund firm piling on and actively raising its costs during a decline - any breakpoints were disclosed in the prospectus and helped you out when the fund was flush - so don't take offense and bail out immediately.

Instead, watch performance and factor expenses in there. Only if costs rise and returns fall relative to a fund's peers will the numbers add up to a possible change in your portfolio.

Chuck Jaffe is mutual funds columnist at The Boston Globe. He can be reached by e-mail at jaffe@globe.com or at The Boston Globe, Box 2378, Boston, Mass. 02107-2378.

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