Bad mutual funds work for firms, but cost shareholders

YOUR FUNDS

June 17, 2008|By CHARLES JAFFE

The only people who like bad mutual funds are the people who run them.

But when a mutual fund firm buys one of its own laggards for investors - or recommends through an its advisory service that investors purchase one of its stinkers for "asset-allocation reasons," that love of a bad fund becomes costly for shareholders.

In the fund world, there's an increasing movement toward funds made up of other funds, wrap programs and advisory relationships where a consumer allows a fund company to build a portfolio. And in many cases, it seems as if the management company doesn't want you to think about what's in your fund, because it's not always their best products.

The question is whether the fund firms are pulling a fast one or doing what they truly believe is best for shareholders, and the answer most likely lies in the eye of the beholder.

Consider, for example, the Vanguard US Growth fund (VWUSX), clearly one of the worst funds in the firm's large stable of offerings. US Growth is a laggard by virtually everyone's standards. It gets the lowest possible marks from Lipper Inc. for total return and preservation of capital. It gets two stars from Morningstar - meaning it has historically generated poor returns for the amount of risk that management has taken on - and it is significantly below-average in its large-growth peer group over the one-, three-, five- and 10-year time periods. Vanguard changed managers several years ago; it hasn't helped much.

Investors have noticed. In 2000, Vanguard US Growth had more than $20 billion in assets. Today, there's about $5 billion left.

Here's the rub: A lot of the money that's stuck around was put there by Vanguard, on behalf of funds like Vanguard STAR and Diversified Equity which invest in sister funds. Ordinary investors have left the fund, while the firm fiddled the same asset-allocation tune - nearly 1 out of 5 dollars in US Growth was put there by Vanguard STAR.

That determination to stand by the fund has observers and even some Vanguard fans scratching their heads.

Dan Wiener, editor of The Independent Adviser for Vanguard Investors Web site, recently told of a letter exchange between a long-time shareholder and Vanguard top dog Jack Brennan over whether the propriety of keeping US Growth in the firm's investment programs. Brennan was angry over the shareholder's insinuations that something funny is going on, but he didn't answer the basic question, which is why the firm keeps relying on a bad fund when it could so easily select something better.

"You're trusting a fund company to allocate your assets - not just Vanguard, but a lot of firms - and they're not necessarily paying attention to the performance of any individual fund," says industry consultant Geoff Bobroff of East Greenwich, R.I. "The board may put a fund on its watch list, but they never make the connection that if they have to put a closer watch on performance that maybe they shouldn't let sister funds put shareholder money into it until the issue is resolved."

Whether it's Vanguard, Fidelity or other firms offering fund-of-funds - and many new retirement-oriented funds are structured this way - experts agree that there has to be a compromise between buying only the hottest funds and staying with laggards. While the former smacks of market timing, the latter smells fishy, particularly when the firm can provide a similar allocation plan with better funds.

"You don't want to see them jumping around and changing funds all the time, but this is a bad fund, and it seems like everyone but Vanguard has come to that conclusion," Wiener says. "I think they owe you some explanation, because it's clearly good for them to keep putting money there, but it's hard to believe it's good for shareholders."

Rebecca Cohen, a Vanguard spokeswoman, disagrees.

"We have heard this type of argument about other funds in the past ... some of it has to do with market cyclicality, at times when growth hasn't really been in favor," Cohen says. "If we were to change our asset-allocation recommendations every time a certain market segment or adviser's approach wasn't in style, we wouldn't serve our investors very well."

"We're not letting past performance drive future decisions," she continues. "We think the advisers in place now have good processes, and the drivers for good future performance are there."

Management might believe that - and their patience might ultimately pay off for shareholders - but accepting the in-house laggard will never sit well with many investors.

Says Bobroff: "This may be the price you pay for convenience, for having a fund family allocate your assets rather than doing it yourself. If you never look at what a fund-of-funds holds, you won't mind, but if you do look at the funds and see a bad one in there, you have a good reason to be concerned because you can't be sure that anyone is really looking out for you."

cjaffe@marketwatch.com

Charles Jaffe is senior columnist for MarketWatch and host of Your Money Radio ( www.yourmoneyradio.com). He can be reached by mail at Box 70, Cohasset, MA 02025-0070.

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