Reduce chances of owning a fund holding disaster stocks

Your Funds

July 07, 2002|By CHARLES JAFFE

NEWS of misleading and fraudulent accounting at WorldCom broke in the middle of last month's Morningstar Investor Conference in Chicago.

The first thing everyone wanted to know was, "Who owned it?" It's the same with each new scandal.

But looking to see which fund held a stock when some final calamity hits is to participate in a witch hunt that can cause the average investor to panic. Whether it's Enron, Global Crossing, Tyco, Dynegy, Adelphia, WorldCom or whatever comes next - and there will be more - fund investors need to be careful about the natural desire to dump any manager caught holding a celebrity blow-up.

Concern over why a fund got snookered is natural; firing a manager for this mistake is a bit extreme, particularly in cases where corporate management simply made things up, rather than bury the facts in footnotes.

"If you sell every fund that has a problem stock, you won't end up with better funds, just with funds that are better at window-dressing," says Russ Kinnel, director of fund analysis at Morningstar Inc. "It's not as simple as `You got fooled, I should dump your fund now' because even the best investors make mistakes."

Window-dressing is a management tactic to which no fund executive will admit but one that everyone suspects the competition of doing. It involves dumping stocks that look bad in favor of hot names, with the swaps typically occurring right before a deadline for the fund to report its holdings in shareholder documents or filings to the Securities and Exchange Commission. In other words, window-dressing makes a fund's portfolio look better than it really is.

For investors, the real issue is not who holds an infected stock when the disease surfaces, but who previously held the stock and missed the symptoms altogether.

The WorldCom news was announced long after the company's stock had declined from more than $40 per share to $2 and less. Funds that rode the stock from $40 down to single digits fried their shareholders, whether or not they still owned WorldCom.

The same thing occurred with Enron. Fund companies seemed to think that pulling the rip cord before the company declared bankruptcy was some sort of salvation for riding the stock down from $80 per share to darned close to nothing.

Top fund managers, particularly aggressive ones, often take a chance on troubled companies. At the Morningstar conference, Wallace Weitz of Weitz Value was one of several managers to own up to holding scandalous companies (Adelphia in his case). During a panel discussion, he noted that the trick is to separate temporary problems from permanent disasters, which can be difficult for even the best investors when numbers are suspect.

Individual investors are often stymied when it comes to determining which fund owns what stocks. Most funds make complete portfolio disclosures only twice a year, and the information is stale by the time investors see it. Fund companies also aggregate their holdings in stocks and file paperwork with the SEC on the issues in which they have big chunks, but these disclosures don't say which specific funds within the family hold a juicy slug of a certain stock and which funds are abstaining from it.

Good managers own up to mistakes, either in quarterly updates, in management discussions on their Web sites or elsewhere. Don't be afraid to call your fund and ask about its exposure to these stocks.

But if one of your funds gets burned by a scandalous stock, ask why the manager purchased that issue in the first place.

If the manager of a value fund bought a stock such as Enron or WorldCom back when the stock was expensive, they paid premium prices and went against the proscribed discipline of trying to buy undervalued companies.

If, however, they bought WorldCom when it was at $2, thinking the company's assets would prop things up, the purchase most likely was appropriate.

There's a big difference between a stock that belongs in the portfolio and a manager being so bedazzled by the numbers - think Enron's growth curve - that he or she breaks with investment discipline.

Ultimately, most experts believe that the funds most likely to get burned by stock scandals are less diversified and shooting for top current-term performance.

Says Kinnel: "The real way to avoid this is to focus on the long-term and buy funds that do the same. The funds that will have big problems with a WorldCom or Enron would be the ones that are good performers for a quarter, not for years on end. ... They may benefit from these stocks on the way up, only to get burned by the scandal on the way down."

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

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