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| BOOK EXCERPT
Business Week Guide to Mutual Funds Ninth Edition
By Jeffrey Laderman
The World of Mutual Funds Note: The online version contains the first nine tables originally created for this chapter. For the remaining tables and figures, please consult the bound book.
You may know you want to invest in mutual funds, but where do you start? At one time, funds pretty much invested in big U.S. corporations. Today, there are funds that specialize in everything from biotechnology to small Asian companies to municipal bonds issued within the boundaries of a single state. The number of funds is so large and investment programs so varied that investors would be overwhelmed without some way to organize the offerings.
TABLE 2-1 EQUITY FUNDS LARGEST HOLDINGS Stock Percent of net assets MICROSOFT 1.14% GENERAL ELECTRIC 1.11 PHILIP MORRIS 0.92 FANNIE MAE 0.76 MERCK 0.75 IBM 0.72 BRISTOL-MYERS SQUIBB 0.71 PFIZER 0.69 CISCO SYSTEMS 0.67 WAL-MART STORES 0.65 INTEL 0.63 AT&T 0.60 MCI WORLDCOM 0.59 TIME WARNER 0.59 WARNER-LAMBERT 0.58 AMERICAN HOME PRODUCTS 0.54 SCHERING-PLOUGH 0.52 TYCO INTERNATIONAL 0.50 EXXON 0.47 AMERICAN INTL. GROUP 0.45 JOHNSON & JOHNSON 0.43 CHASE MANHATTAN 0.42 DELL COMPUTER 0.42 AMERICAN EXPRESS 0.40 HOME DEPOT 0.40 DATA: MORNINGSTAR INC. The truth is that this definition gives an investor little guidance on exactly how the fund achieves that growth. Vanguard U.S. Growth Fund takes a fairly traditional growth route, buying stocks in blue-chip growth companies such as Microsoft, General Electric, Pfizer, Intel, and Coca-Cola. The median market capitalization (total market value of a company's shares) of all the stocks in the portfolio is $86.5 billion. At the other end of the growth-fund spectrum is Lindner Growth Investors, which, judged by its portfolio, has little in common with Vanguard U.S. Growth Fund. Among the largest holdings are Alliant Techsystems, Old Republic International, Unisys, and Marine Transport. Recognize any of these names? Perhaps Unisys, if you're in the computer business. By and large, they're not household names, and they're much, much smaller companies. The median market capitalization is only $457 million, less than 1 percent of that of Vanguard U.S. Growth. Are these two funds at all alike? Other than the fact that both are growth funds that invest in equities, no. It's not even that one invests in very large companies, the other in very small companies. The companies the funds choose differ in more than size. Vanguard U.S. Growth's companies sell, on average, at 11.2 times their "book" value, which, simply put, is the value of the company's assets that are "on the books" less the liabilities. It's what the accountants say the company is worth. That may seem high, but the key here is earnings growth, not book value. On that side, Vanguard U.S. Growth's companies are well above average for large companies--an average 18 percent growth in earnings a year over the last three. Lindner Growth's companies, on the other hand, sell for just 2.2 times book value. Why so low? Well, these companies are often out of favor with investors. Look at the three-year earnings growth rate--in this case, just 12.6 percent--and you can understand why these stocks are out of favor. So why do the managers of the Lindner Growth fund want to invest in them? They believe that the stocks are undervalued and certain changes are going on in the companies that will result in the market's ultimately recognizing that value. These changes might be an upturn in earnings, an exciting new product, a corporate restructuring, or perhaps even a merger. In the investment world, Vanguard's stocks would be considered a "growth" portfolio; Lindner's, a "value" portfolio. We can also characterize the funds by the median market capitalization of the stocks they hold. Vanguard U.S. Growth is definitely large-cap, the Lindner fund, small-cap. Use the two characteristics to describe each fund and you get large-cap growth and small-cap value. Those are two very distinct "investment styles," both of which, when executed well, have the capability to make money. Of course, not all investment styles do equally well all the time. For instance, Vanguard U.S. Growth bested Lindner Growth every year since 1994, but the Lindner fund beat the Vanguard fund in 1992 and 1993. That's one of the reasons it's important to examine mutual funds by their styles. Properly categorized, style tells you more about how the fund invests than the "investment objective." Investment style also tells you more about what to expect from your fund. Consider the widely varying performances of large-cap growth and small-cap growth funds, many of which are nonetheless categorized as growth funds. Small-cap growth stocks have woefully underperformed large-cap growth stocks since mid-1996, so you would expect a small-cap growth fund to have underperformed as well. These categories are not entirely new. Several years ago, business week started to report investment style in the Scoreboard while still using the old investment objectives for grouping funds. Now we are categorizing funds in the Scoreboard and in this chapter by style. That means it will be easier for investors to compare funds with like investment programs. For example, an investor might decide to switch her money from Growth Fund A to Growth Fund B because the two are growth funds and B has been performing much better than A. But a stylistic analysis reveals an explanation for the disparities in returns: Fund A is a small-cap growth fund, Fund B a large-cap growth fund, and large-caps have been trouncing the small-cap stocks. There are other good reasons for looking at funds through this stylistic lens. For instance, most fund investors today own more than one fund, with the idea that diversification among funds is a good idea. Suppose an investor owned the Kaufmann, AIM Capital Development, Baron Growth & Income, and Robertson Stephens Emerging Growth funds. Using investment objectives to categorize funds, the investor would have a maximum growth, a growth, a growth and income, and a small company fund and think he's getting diversification. Yet, in a stylistic analysis, all are small-cap growth funds, and it's likely they're making many similar investments. Is that the diversification the fund investor was seeking? A fund investor who is trying to build a diversified portfolio of funds will have an easier time doing it by using stylistic categories than by using the traditional investment objectives. One more good reason for using style analysis on funds is that it looks beyond labels and marketing hype. For instance, fund companies sometimes give their funds names that track one investment objective when the funds actually pursue another. Look at Robertson Stephens Growth & Income Fund. Most growth and income funds strive to produce some dividend income, so they must invest a good portion of the fund assets in stocks that pay dividends. Such stocks are less volatile than growth stocks that don't pay dividends. Yet the fund's portfolio behaves more like a growth fund than a growth and income fund. The reason: portfolio manager John Wallace does not invest like the majority of growth and income managers. He puts most of the fund's money into high-octane growth stocks that don't pay dividends. For the income component, he invests in convertible bonds and eschews the conservative dividend-paying stocks commonly found in his competitors' funds. Though it hasn't been the case in the last few years, this strategy had long enabled Wallace to outshine the other growth and income fund managers. Is it right for Robertson Stephens Investment Management to call this a "growth and income" fund? Well, the definition of that investment objective is broad enough and vague enough to allow the Robertson Stephens fund to fit within it. But to call it a growth and income fund might stretch credibility a bit, since it neither invests like most of those funds nor produces returns that look like most of the other growth and income funds. When it outperforms other growth and income funds, do investors really understand it's doing so because it's taking greater risks and investing like a growth fund? One way of compensating for this sort of unexpected behavior is to ignore the objective listed in the fund's prospectus and put the fund into a different objective group. Morningstar, for instance, has done this on occasion to better describe a fund's behavior. For the last several years, the fund research firm has put Warburg Pincus Growth and Income Common Shares into its growth fund category, even though "income" is in the name. And it seems appropriate. During 1998, the fund paid out only 0.7 percent in yield, which is less than what would be expected in a growth and income fund, even when yields on equities are at record lows. But moving errant funds into different categories isn't enough if the categories themselves are inadequate for today's investment world. Suppose Robertson Stephens Growth & Income Fund was reclassified as a growth fund. An investor still runs into the same kind of problem described earlier with Vanguard U.S. Growth and Lindner Growth Investors--growth funds encompass a myriad of investment styles. So, comparing growth funds to growth funds isn't always a fair comparison, either. Robertson Stephens Growth & Income is a growth fund investing in midsized companies, while Lindner Growth Investors invests in small-cap value stocks. Style-based categories give investors much better descriptive information about funds than the traditional investment objectives. The style analysis comes right out of the fund's portfolio. Investment objectives come out of a document written by marketing executives and lawyers. Which would you rather trust?
You don't need an MBA to look at the holdings of a mutual fund and tell whether they're large or small companies. But Morningstar analysts don't eyeball the portfolios to determine their median market caps or whether the stocks fall into the growth or value camp. There's a method to it.
TABLE 2-2
THE NEW MUTUAL FUND CATEGORIES
VS. THE OLD INVESTMENT OBJECTIVES
New Old
EQUITY FUNDS
Large-cap Value Maximum Growth
Large-cap Blend Growth
Large-cap Growth Growth and Income
Mid-cap Value Equity-Income
Mid-cap Blend Small Company
Mid-cap Growth
Small-cap Value
Small-cap Blend
Small-cap Growth
Domestic Hybrid Balanced
International Hybrid Asset Allocation
Multiasset Global
Diversified Emerging Markets Diversified Emerging Markets
Foreign Foreign
World World
Europe Europe
Diversified Pacific Pacific Basin
Pacific ex-Japan
Japan
Latin America
BOND FUNDS
Long-Term (Gen.) Corporate-General
Intermediate-Term (Gen.) Corporate-High-Quality
Short-Term (Gen.) Corporate-High-Yield
Ultrashort Government-General
Long Government Government-Adjustable-Rate Mortgages
Intermediate Government Government-Mortgage
Short Government Government-Treasury
Municipal National Long Municipal-National
Municipal Nat'l. Intermed. Municipal-Single-State
Municipal Single-State Long Municipal-California
Municipal Single-State Intermed. Municipal-New York
Municipal California Long Convertibles
Municipal California Intermed. World Bond
Municipal New York Long Short-Term World Income
Municipal New York Intermediate
Municipal Short
High-Yield
Convertibles
International
Emerging Markets
Multisector
*No change in the specialty equity funds.
DATA: MORNINGSTAR INC., BUSINESS WEEK
As industries, companies, and even stock markets have become more global, so have mutual fund portfolios. Our guidelines allow a domestic fund to have up to 40 percent of its holdings in non-U.S. companies and still be a domestic fund. Funds with more than 40 percent of their holdings in non-U.S. companies are considered international. Thus, SmallCap World Fund, which you might surmise is an international fund investing in small companies, is now considered a domestic small-cap growth fund since it has only 38 percent of its assets abroad.International funds are cut broadly and regionally. Foreign funds invest almost entirely in non-U.S. markets, though they can have up to 10 percent of their assets in the United States. World funds are just the opposite--they can invest anywhere and must have no less than 10 percent of its assets at home. Diversified emerging markets funds must have at least 50 percent of their assets in the emerging markets. Regional funds--Europe, Latin America, Japan, Diversified Pacific, and Pacific ex-Japan--must have at least 75 percent of their assets invested in their designated region. Our bond fund line-up also tracks Morningstar's. At business week, we no longer use the conventional bond fund objectives that categorize funds mainly by the kinds of bonds they buy--government, corporates, or municipals. Our classification considers both the type of bonds a fund buys and the average maturity or duration of the fund's bonds. A long-term bond fund is one with a duration (a more refined measure of maturity that we'll discuss later in this chapter) greater than 6 years; an intermediate-term fund has a duration of greater than 3.5 years and less than 6 years; a short-term fund, less than 3.5 years but greater than 1 year. There's one ultrashort category that encompasses both government and corporate bonds, with a duration of less than a year. Municipal funds are organized into national and single-state long- and intermediate-term categories, but all short-term muni funds, whether national or single-state, are in the same category. With muni funds, the definitions of long-term, intermediate-term, and short-term are a little different. A long-term fund has a duration greater than 7 years; intermediate, between 4.5 and 7 years; and short, less than 4.5 years. Shuffling the bond fund categories makes selecting bond funds and tracking their returns much simpler. It's easier to see how well a fund is performing if you compare it to a fund with a similar maturity and duration. On this count, bond funds have always been a little easier to understand than equity funds since many have "long-term" or "intermediate" in their titles. Still, by rating funds in their own categories, investors will be able to see more quickly which long-term U.S. government fund has not only the best return but also the best risk-adjusted return as well. Not all bond funds fit into these categories. Convertible bonds and high-yield bonds, which in many ways have as much to do with the equity market as interest rates, retain their own categories. There's no further differentiation for intermediate or long-term bonds. Most high-yields (and convertibles, too, since most of them are less than investment grade) fall in the short-to-intermediate-term range. International bonds is a broad category for the funds that invest in mainly investment-grade non-U.S. bonds. Emerging markets bond funds contain securities backed by nations like Thailand, Brazil, and Russia. In other words, the instruments are bonds but they are riskier than many, many stocks. LARGE-CAP VALUE FUNDS You know you should invest in equity mutual funds, but somehow the volatility of the stock market and the possibility of losing your money scare the daylights out of you. If this describes you, try a fund that invests in large-cap value stocks. Of the nine categories of domestic equity funds, these funds are the least risky and perhaps the most palatable for the anxious investor. Most of the funds in this category were formerly in the growth and income and equity-income investment objectives. They keep one eye on downside risk and the other on a stock's upside potential. Some of the larger and better-known funds in this category are Fidelity Equity-Income, Fidelity Equity-Income II, Fidelity Destiny I, Fidelity Destiny II, Vanguard Windsor, Vanguard Windsor II, and Washington Mutual Investors. Just because these funds are cautious doesn't mean they can't perform well. During 1997, the funds earned an average 26.7 percent total return--nearly 10 percentage points better than the average fund. In 1996, for instance, the 2 large-cap value funds among the 20 largest equity funds beat the S&P 500. Nineteen ninety-eight, though, was, to put it mildly, a big disappointment for these funds. The average large-cap value fund gained just 12.8 percent, 1.3 percentage points behind the average U.S. diversified equity fund and nearly 16 percentage points less than the S&P 500. The best-performing large-cap value fund in 1998 was Legg Mason Value Trust Primary Shares, up 48.0 percent (Table 2-3). It was also the best performer in the 3-, 5-, and 10-year periods. In some ways, it's an atypical fund--but more about that later.
TABLE 2-3
LARGE-CAP VALUE FUNDS
BEST RETURNS
Period Fund Total return*
1998 LEGG MASON VALUE PRIMARY SHARES 48.0%
1996-98 LEGG MASON VALUE PRIMARY SHARES 41.1
1994-98 LEGG MASON VALUE PRIMARY SHARES 32.0
1989-9 LEGG MASON VALUE PRIMARY SHARES 20.9
*Average annual, pretax
DATA: MORNINGSTAR INC.
Why has this category of fund made such a poor showing of late? One is the nature of the stocks these funds buy. No high-flying semiconductor or software stocks here for the most part, but you'll recognize the names: Philip Morris, IBM, Fannie Mae, and AT&T (Table 2-4). To most value investors, what makes a stock attractive is that it's cheap. Don't confuse cheap with a low price, like $5 or $10 a share. A share of stock is said to be cheap only when it's measured by some valuation criteria such as the p-e ratio and/or p-b ratio and then compared to a benchmark, like the p-e or the p-b of the S&P 500.That a stock is cheap--suppose it has a lower-than-average p-e ratio--is no guarantee against losing money, since a cheap stock can always get cheaper. But think of it this way: If the market gets hit with a downdraft, cheap stocks can fall, but usually not as far or as hard as expensive stocks. Chances are, you're going to lose more money if an expensive stock becomes cheap than if a cheap stock gets cheaper.
TABLE 2-4
LARGE-CAP VALUE FUNDS
LARGEST HOLDINGS
Stock Percent of net assets
PHILIP MORRIS 1.67%
AT&T 1.29
FANNIE MAE 1.19
IBM 1.15
AMERICAN HOME PRODUCTS 0.90
GENERAL ELECTRIC 0.89
CITICORP 0.83
CHASE MANHATTAN 0.83
FIRST UNION 0.83
FORD MOTOR 0.81
DATA: MORNINGSTAR INC.
That didn't happen in 1998. In fact, conventional wisdom was turned upside down. When the stock market tanked in the summer, the large-cap stocks that did the worst were the financial, natural resource, and energy stocks that these funds tend to own. Even the large-cap value funds' emphasis on dividend-paying stocks didn't help much.Still, these are all long-term investments, and you shouldn't be deterred by a subpar year. There are many solid funds in this category, and they almost invariably have low or very low risk when compared to those in other categories of funds. Many of them use the term "equity-income" in their name. Look at the Fidelity Equity-Income offerings, which stipulate that at least 65 percent of the stocks in the fund must be dividend payers. There's a reason for this: that a company is able to pay a dividend suggests that it is generating cash above and beyond its needs and is not likely to go broke. Vanguard Equity-Income follows a "relative yield" strategy, buying stocks when their yields are high relative to where they have been over time. That's usually a sign a stock is out of favor at the moment, a true contrarian strategy. If the managers believe the dividend is sustainable and can even grow, they'll buy the stock for the fund. When the stock comes back into favor, the price will go up, and that yield will drop--and eventually it may even drop out of the fund, but at a profit. In recent years, neither investors nor companies themselves have paid much attention to dividends. Investors preferred to buy stocks that had greater growth potential than is available in most dividend-paying stocks. And companies themselves responded to the market's appetite for share appreciation by deploying excess cash to buy back shares rather than hike dividends. Some investors argue it's not a bad thing to do. Dividends are considered ordinary income and are taxed at the same rate investors pay on their salary and interest income, which can be as high as 39.6 percent (and that's just the federal tax). When companies buy back shares instead of boosting their dividends, the only shareholders that get taxed are those who sell their shares. If those shares were held for longer than a year, any profits would be taxed at the more favorable long-term capital gains rate, a maximum of 20 percent. Since these large-cap value funds generate fully taxable dividend income, many advisers counsel high-income investors to use them only in tax-deferred accounts like 401(k)s and IRAs. In such accounts, there's no tax liability until the investor retires and starts drawing the money out. Be forewarned that many veteran investors take dividends seriously. In bear markets, a situation that many of today's investors have not experienced, a steady dividend stream becomes a primary support of a stock or a portfolio of stocks. After all, the only way to make money in stocks is through capital appreciation and dividends. When the appreciation part is in doubt, the security of a dividend payout starts to look a whole lot better. Even though they buy many of the same big, cheap, dividend-paying stocks, some funds in this category stand out with their own particular quirks. Vanguard Windsor (which is closed to new investors) is not afraid to concentrate its positions. Its 10 largest holdings amount to some 38 percent of the $18.2 billion portfolio. Unfortunately, that did not work well for the fund in 1998. The total return was just 0.8 percent--the fund's worse showing since 1994. The Clipper Fund's stocks usually pay dividends, but they're not chosen on a dividend basis alone. What Clipper looks for are companies with solid and sustainable business franchises at cheap prices, and among the current holdings are Philip Morris and Fannie Mae. The managers will sell the stock when it becomes fully valued--as it did with Wal-Mart Stores in 1998. The fund had acquired the giant retailer when its stock was in the 20s, and sold it in the 60s--only to see it go higher. What makes Clipper different from many other funds, both in its category and among all equity funds, is that it will let cash build up rather than lower its investment standards. At the end of 1998, the fund held about 36 percent cash, a significant drag on performance in an up market. Still, the fund is A-rated both when compared to all funds and when compared to other large-cap value funds. (For investors who want Clipper's stocks but not the cash, it just opened the Clipper Focus Fund.) Vontobel U.S. Value takes a similar approach. It concentrates investments in what it believes to be truly undervalued positions and, if necessary, lets cash build up. In 1998, Vontobel's 10 largest positions amounted to 79 percent of the fund, and cash amounted to about 19 percent. Vontobel U.S. Value earned A's both for overall performance and for performance within its fund category. Then there's Legg Mason Value. In the mid-1990s, portfolio manager Bill Miller loaded the fund with beaten-up financial stocks--a typical move for a value manager--and they paid off. Around the same time, Miller did something atypical for many managers. He bought stakes in America Online and Dell Computer. At the time, Wall Street was wary of both companies. AOL had just gone to flat-rate pricing, subscribers were outraged by an inability to get on the network, and the company's accounting for its huge marketing expenses was under attack. But Miller saw what AOL might become if it could straighten out its problems--and it did. The same happened with Dell Computer, which most pros at the time dismissed as just another PC manufacturer in a cut-throat business. But Dell, by selling direct to customers, building computers to order, and avoiding costly dealer networks, became the most profitable PC company by far. Still, both companies were unusual buys for a value fund since most shy away from technology companies even when they're out of favor. But perhaps even more unusual is that Legg Mason Value kept the stocks as they went from underpriced to what most professional investors would argue is very high-priced. Miller has sold very few of the stocks, and at the end of 1998, the two companies together comprised nearly a quarter of the portfolio. His argument is that the stocks still have great prospects. If Legg Mason is so heavily weighted in these richly valued technology stocks, why is this still a value fund? The rest of the portfolio is classic value, with companies like Fannie Mae and Phillip Morris. Under Morningstar's statistical test, it's still a value fund, though one of these days it might well cross over to the "blend" column in the style box. Some analysts interpret such huge concentrations as Legg Mason's as risky, since there are more eggs in fewer baskets. Managers of these risk-shy funds see it differently. Good value investments are hard to come by, so when you find them, you have to make the most of them. This buy-and-hold tendency is reflected in the low turnover ratios that are not much more than half the average for equity funds. A-rated Washington Mutual Investors, part of the American Funds family, has a low turnover as well, perhaps because there aren't that many stocks it can invest in. That's because the fund follows the Prudent Man Rule, a rule for fiduciaries that dictates that every investment in the fund must pass certain quality standards and pay a dividend. According to Morningstar analysts, fewer than 300 stocks are even eligible for investment by the fund. Lexington Corporate Leaders, another large-cap value fund, also has a rather select portfolio. In fact, it's almost a static portfolio. The fund goes back to 1935 and was set up to invest in 30 stocks its founders thought would prosper for years to come. The portfolio manager has the ability to sell a stock, but cannot add a new name. Still, most of the original 30 survive, and they include such companies as Procter & Gamble, General Electric, AT&T, DuPont, and Exxon. Even more amazing, the fund has been a strong performer over the last 10- and 15-year periods, but in the bottom half of its category in the last few years. Except for Lucent Technologies (the result of an AT&T spin-off), there are no high-tech or pharmaceutical stocks. Although you would not expect to find these kinds of stocks in any great number in a true value fund, this fund is not a value fund by design--just as a result of its unusual investment policy. Had stocks like IBM and Merck been in the original mix, they'd still be there today--and the fund's recent returns would have been a whole lot better. LARGE-CAP BLEND FUNDS Some investment managers call themselves value investors, and others growth investors. But you'd be hard pressed to find investment managers who call themselves blend investors. The blend fund, however, is sort of the vast middle--the huge category into which fall all the funds that don't strongly gravitate to either side of the investment world. The blend funds have attributes of both the growth and value styles. What makes them a blend is that when the portfolio statistics are calculated, the numbers fall in the middle. According to Morningstar's criteria, the combined p-e and p-b ratios of these funds can be no more than 12.5 percent greater than or 12.5 percent less than the combined p-e and p-b ratios for the S&P 500. The best performer of 1998 was Alliance Premier Growth B, with a 48.3 percent total return (Table 2-5). Not only is this fund a leader in its category, but in the entire fund universe. Portfolio manager Alfred Harrison powered the fund over the last few years with bets first on financial and later on technology stocks. Top holdings include Dell Computer, Cisco Systems, and Nokia, and Harrison is not afraid to let his winners run. The top 10 holdings comprise 45 percent of the portfolio. TABLE 2-5 LARGE-CAP BLEND FUNDS BEST RETURNS Period Fund Total return* 1998 ALLIANCE PREMIER GROWTH B 48.3% 1996-98 RYDEX NOVA INV. 34.2 1994-98 RYDEX NOVA INV. 28.2 1989-98 FIDELITY CONTRAFUND 24.0 *Average annual, pretax DATA: MORNINGSTAR INC.As the Alliance fund demonstrates, blend does not have to be bland. Large-cap blend is a huge category (the largest of the nine categories of U.S. diversified equity funds), and it includes many well-known funds: Fidelity Magellan, Fidelity Growth & Income, Investment Company of America, and T. Rowe Price Blue Chip Growth. While the giant Magellan made a comeback in 1998, it had difficulties for several years before that. Fidelity Growth & Income's returns have remained top-notch, and it still merits A ratings for overall and category performance. If you aren't in it already, it's too late. In 1998, Fidelity closed the fund to new investors and opened Growth & Income II, with a similar investment objective but a different manager. Still, anyone running these funds will work from the same palette of investments. Among the largest holdings of these funds are General Electric, Philip Morris, Microsoft, and Merck (Table 2-6).
TABLE 2-6
LARGE-CAP BLEND FUNDS
LARGEST HOLDINGS
Stock Percent of net assets
GENERAL ELECTRIC 2.17%
MICROSOFT 2.07
PHILIP MORRIS 1.42
MERCK 1.39
WAL-MART STORES 1.26
INTEL 1.25
BRISTOL-MYERS SQUIBB 1.23
FANNIE MAE 1.19
IBM 1.18
PFIZER 1.08
DATA: MORNINGSTAR INC.
Two other Price offerings in this category are also top-rated: T. Rowe Price Blue Chip Growth Fund and T. Rowe Price Dividend Growth Fund. Dividend Growth Fund has a risk profile similar to Equity-Income, but a much smaller asset base. Blue Chip Growth managed to earn a much higher than average return (28.8 percent) in 1998 without gorging on high-priced high-tech stocks. Dividend Growth, while retaining it's double A ratings, had a difficult year and only earned 15 percent. The funds bias for dividends--and the lack of them in the overall market--prompted manager Bill Stromberg to seek them in real estate investment trusts, a type of investment that was cheap when the year started and got even cheaper as the year went on.But perhaps the most compelling--and sometimes controversial--of the large-cap blend funds are the index funds that replicate the S&P 500. Such funds have been enormously successful in recent years, mainly because the large-cap stocks that account for a large chunk of the S&P 500's performance have done so well. Unlike most "managed" funds, index funds are capitalization-weighted, meaning stocks with larger capitalizations weigh more in the calculation of the index than those with smaller capitalizations. So when large-cap stocks outperform small-cap and mid-cap stocks, S&P 500 index funds do very well. The other way in which index funds differ from most others is that rather than take profits in winners, they let their winners roll. There's no limit on how large Microsoft and General Electric, which move back and forth as the S&P 500's and the U.S. market's largest stocks, will be allowed to become. Index fund managers, unlike managers of conventional funds, never sell a stock too early. Looking back on the last few years, index funds look like a no-brainer way to riches. Many of our A-rated funds are S&P 500 index funds, in part because of their own strong performance and in part because of the lagging performance of the other mutual funds against which they are judged. The largest index fund, the $74.2 billion Vanguard 500 Index, is one of the fastest growing of the large funds, and during 1999 should overtake the long-time leader, the $83.6 billion Fidelity Magellan Fund. Index funds have several other attributes that make them winners, such as low expenses. The Vanguard 500 Index has an expense ratio that is one-seventh that of the average fund. Index funds are also low in portfolio turnover, which keeps trading costs down. Low turnover also means little in the way of taxable distributions. In fact, while most funds have failed to beat the S&P on a pretax basis, even fewer do it after taxes. Although most of the money flowing into index funds in recent years came through tax-deferred retirement programs, index funds are perhaps even more effective in a taxable account. Does this make an S&P index fund a must-buy investment? It's hard to argue against it. Certainly, many investors can benefit by having some portion of their equity portfolio in an index fund. But viewing the index fund over the last 5 years alone, or even 10 years, can be misleading. The stock market has had an extraordinarily good run during that period. But if the market were to fall badly over an extended period (not the three-month pullback of 1998), the index funds might not look so good. For starters, there's no safety net. Index funds don't carry cash, which cushions a fall, and unlike active managers, they can't deploy more of their assets to "defensive" sectors like utilities or food stocks. Although these actions by active managers can hold a fund back during a bull market, when properly deployed, such actions can soften a downturn. So, when you are considering index funds, remember there is that drawback. Indexing itself does not have to be boring. Look at the Rydex Nova Fund. Though designed for market-timers, Rydex will open the door for anyone with a relatively steep $25,000 minimum investment. By design, the Nova fund seeks investment returns that correspond to 150 percent of the performance of the S&P 500. So if the S&P is up 20 percent, this fund should go up 30 percent. Likewise, if the S&P goes down 20 percent, this fund should go down 30 percent. The fund hasn't been able to hit that 150 percent goal; in 1998, for instance, its return was just 123 percent of that of the S&P 500, and in 1997, 126 percent. For the three-year period, the return was about 121 percent of the S&P. Rydex runs the fund without a share of stock. It's managed with a combination of cash, futures, and call options. Rydex Ursa Fund is an index fund in reverse. It's managed to move in the opposite direction of the S&P 500, so its fat 19 percent loss in 1997 is neither unexpected nor a sign of portfolio ineptitude. Ursa, the Latin word for bear, is designed to win in a bear market. Its mission is to move in the opposite direction of the S&P 500. (It's run with a combination of cash, options, and futures.) When the stock market dives, Ursa shines. Between July 17, 1998, the summer's peak in stock prices, to August 31, the bottom, the S&P 500 dropped 19.3 percent. Rydex Ursa gained 24 percent. LARGE-CAP GROWTH FUNDS For the last several years, Wall Streeters dabbled with small-cap and mid-cap stocks but ultimately fled to the safety of large-cap growth stocks. There was good reason for this. At every hint of a slowing economy, these companies--with a clearly defined, "visible" earnings outlook--seemed more and more attractive in an uncertain economic environment. The major stocks in these funds tended to be larger high-tech companies and defensive consumer stocks like food, drugs, and beverages. The best fund in this category for the last five years is White Oak Growth Stock Fund (Table 2-7). That fund made enormous gains with high-tech and pharmaceutical stocks, and its largest holding of late is drugmaker Eli Lilly. Over the 10-year period, the winner is Janus Twenty, which in 1998 earned a 73.4 percent total return. That's extraordinary for any fund, but even more remarkable for a fund that already had $6 billion in assets at the start of the year. Janus Twenty, which concentrates most of its portfolio in about two dozen stocks, scored big with high-tech, telecom, and drug stocks. Its high-octane performance is also testament to what a concentrated portfolio can do when most everything goes right.
TABLE 2-7
LARGE-CAP GROWTH FUNDS
BEST RETURNS
Period Fund Total return*
1998 PROFUNDS ULTRAOTC INV. 185.3%
1996-98 RYDEX OTC INV. 48.1
1994-98 WHITE OAK GROWTH STOCK 30.1
1989-98 JANUS TWENTY 25.8
*Average annual, pretax
DATA: MORNINGSTAR INC.
The best performers for the one- and three-year periods didn't earn their returns quite the same way as the managers of White Oak Growth or Janus Twenty. Profunds Ultra OTC Investors and Rydex OTC Investors are index funds investing in the NASDAQ 100 index, an index of the largest over the counter stocks. You won't find any of the stocks in that index trading on the prestigious New York Stock Exchange, but so what? This index is the home of Microsoft, Intel, Cisco Systems, and Dell Computer. Of course, these stocks are all in the S&P 500, but not in such concentrations. Microsoft is 3 percent of the S&P, but 16 percent of the NASDAQ 100. So just tracking an index dominated by these winning stocks has been a winning strategy. That's why Rydex OTC was up 86.5 percent in 1998 and an average of 48.1 percent per year for the 1996-
1998 period.But consider the brash new kid on the mutual fund block, ProFunds UltraOTC Investors. Like Rydex OTC, it's designed to replicate the NASDAQ 100--but then goes a step further. Using futures and options, this fund is leveraged two-to-one. That means for every 1 percent move in the NASDAQ 100, this fund should go 2 percent. No wonder it was the best large-cap growth fund in 1998, up 185.3 percent. (Actually, it did better than twice the index.) And, of course, that means it would fall twice as much on the downside. The question to consider when investing in these funds is, how long can these large-cap growth stocks continue their winning streak? The conventional wisdom about successful large companies is that inertia will eventually overtake them. Rapidly growing companies become above-average growers, above-average turns out to be average. The slowdown in growth is predictable--in theory. The art of investing in these companies is getting the timing of that growth right, to buy at a p-e ratio that's fair relative to the growth rate. Look at Cisco Systems, a principal manufacturer of servers and related equipment to tie together computer networks. It's one of the top holdings of the large-cap growth funds (Table 2-8). The company has gone from annual sales of nearly $70 million in fiscal 1990 to $8.5 billion in fiscal 1998. That's about a compounded annual growth rate of 82 percent a year; during the same time, net income grew at a compounded average annual rate of over 9000 percent. (Is there any doubt why this is such a great company?) Cisco is still growing at a fast clip; the last fiscal year showed 31 percent revenue growth over the previous year. But it's no longer growing at the same torrid pace of five years ago. (At that time, you would have found Cisco not in a large-cap growth portfolio, but in a small or mid-size fund.) Now the earnings growth rate is forecast to be about 29 percent. That's a far cry from what it was, but it's still four times that of the average big-company stock. At the end of 1998, Cisco sold for about 63 times the estimated fiscal 1999 earnings. While high valuations for top-notch growth stocks can be justified, 63 times earnings--twice the forecasted growth rate--is a price that leaves little room for disappointment.
TABLE 2-8
LARGE-CAP GROWTH FUNDS
LARGEST HOLDINGS
Stock Percent of net assets
MICROSOFT 3.70%
PFIZER 2.54
CISCO SYSTEMS 2.45
GENERAL ELECTRIC 2.40
WARNER-LAMBERT 1.76
MCI WORLDCOM 1.62
DELL COMPUTER 1.59
MERCK 1.58
TIME WARNER 1.55
INTEL 1.40
DATA: MORNINGSTAR INC.
The apparent risks notwithstanding, there's a reason why the market values these companies highly. They are superb companies. Many of these companies, though based in the United States, are world-class leaders with substantial operations outside the United States. Coca-Cola, for instance, has no equal anywhere on the planet, and most of its profits are generated outside the United States. Nor does any semiconductor company even approach Intel. Mutual funds that identify and invest in these sorts of companies early on can make a bundle for their investors.The exceptionally strong returns earned by these funds may be masking some unrealized risks. These large-cap growth stocks are the most closely watched on Wall Street (they're the so-called "institutional favorites" you hear about in stock market reports), and they're said to be the most efficiently priced. To stand out in this category, a fund manager has to make some serious sector bets, concentrating holdings in a few areas that he or she thinks will do a lot better than the large growth stocks in general. During 1998, for instance, MFS Massachusetts Growth Stock Investors A had about 29 percent of its assets in technology stocks versus 23 percent for the large-cap growth funds and 18 percent for the S&P 500. Fortunately, that bet paid off--the fund was up 40 percent in 1998--but it could have been a big depressant on the fund had it not. Other noteworthy funds in this category include Dreyfus Appreciation, Gabelli Growth, Papp America-Abroad, Vanguard U.S. Growth, and Vanguard Growth Index. Perhaps one of the most interesting of the large company growth funds is Stein Roe Young Investor Fund, a fund with a mission to invest in securities issued by companies that affect the lives of children and teenagers. The idea is perhaps more marketing oriented than market oriented. No doubt Stein Roe marketers thought the fund would be a natural for parents and grandparents to buy for their kids. And, in fact, the company developed sales literature and shareholder reports that even a kid could understand. The reality is that the fund can invest in almost anything. The largest holding is Cisco Systems. The connection? Well, Cisco builds computer networking equipment, and, well, kids go on the Internet, no? As a practical matter, it's hard to think of a company with a business that couldn't in some way be linked to kids. (A steel company? This company is a supplier to the automakers, who use it to build vehicles that parents use to chauffeur their children.) You don't have to be a young investor to invest in or profit from this fund. MID-CAP VALUE FUNDS It's difficult to generalize about mid-cap value funds, or, for that matter, any kind of mid-cap fund. Funds that fit into one of the corners of the nine-category box--large-cap value, large-cap growth, small-cap value, and small-cap growth--are the most discriminating about how they invest. Look inside the portfolio of a small-cap growth or large-cap value fund, and you won't mistake it for anything else. Many mid-cap value funds have long used the term value in their names, but only in the last few years have some funds started to call themselves mid-cap or even mid-cap value. Pioneer Three Fund changed its name to Pioneer Mid-Cap Fund in 1996. A few months later, Lord Abbett Value Appreciation Fund was renamed Lord Abbett Mid-Cap Value Fund. What's behind the name changes? One reason is the recognition of investor interest in funds that define their investment style. The other reason may be marketing. Neither the Pioneer nor the Lord Abbett fund had distinguished track records, so there was nothing to lose in changing the names. If nothing else, it might attract money that's looking for a mid-cap home. Still, many mid-cap funds--including value, blend, and growth varieties--didn't set out to be mid-caps. They sort of backed into it. Take, for instance, Oakmark Select Fund. The fund says nothing about mid-caps in its prospectus, but nearly all the holdings of the fund are unambiguously mid-cap in nature. One explanation for this is that the Oakmark Fund, the Select's big brother, was a mid-cap value fund until 1997, when its holdings became large enough to move into large-cap value. Since the Oakmark family already had a small-cap fund, it made sense for the newest member, Oakmark Select, to troll in mid-cap waters. The other explanation: the fund became a mid-cap value fund as a result of the investments it made, not because it sought to make specifically mid-cap investments. That's much the case with Weitz Partners Value Fund, the top-performing mid-cap value fund of 1998 (Table 2-9). Weitz Partners Value, along with sister fund Weitz Value Fund, were the only mid-cap value funds to get an A for overall performance for the 1994-1998 period. Portfolio manager Wallace Weitz says his recent success was based on a heavy concentration of cable television and cellular phone stocks. Neither sectors are heavily represented in the value funds, but Weitz said they appeared to be compelling investments. He loaded up, and he turned out to be right in his assessment. The Sound Shore Fund, rated A when compared to other mid-cap value funds, also arrives in this category as a result of what it bought; its prospectus says nothing about sticking to mid-cap investments. However, beyond its three largest holdings, most of the stocks in this concentrated portfolio are mid-cap companies.
TABLE 2-9
MID-CAP VALUE FUNDS
BEST RETURNS
Period Fund Total return*
1998 WEITZ PARTNERS VALUE 29.1%
1996-98 THORNBURG VALUE A 31.1
1994-98 FIRST EAGLE FUND OF AMERICA Y 21.9
1989-98 FPA CAPITAL 20.1
*Average annual, pretax
DATA: MORNINGSTAR INC.
Perhaps the best known of the mid-cap value funds are the original Mutual Series Funds--Mutual Shares, Mutual Qualified, and Mutual Beacon. (Our Scoreboard reports on the Z-share class, which is the longest standing and largest.) They're three of the five largest funds in this category. Like many mid-cap value funds, these funds include a wide range of investments chosen more for their attractiveness as value plays than to meet any market capitalization target.One of Mutual Series' biggest successes of recent years was its 1995 foray into Chase Manhattan Corp. Mutual Series management took a large stake, then lobbied the Chase management and the board of directors, into taking action to improve shareholder value. That's the buzz word for "get the stock price up--or else." Other large shareholders took note as well, and joined in the chorus. In several months' time, Chase agreed to a merge with rival Chemical Banking Corp. to create a bank holding company larger than Citicorp. Even while participating in the megabanking play, the portfolios remained mid-cap in character. Mutual Series funds still own a good chunk of Chase Manhattan stock, and because of those funds' size, Chase is the No. 1 holding of the mid-cap value funds, comprising 1.56 percent of total net assets (Table 2-10). Several other of Price's largest holdings also appear on this list: MediaOne Group, RJR Nabisco Holdings, and Investor Cl.B. (a Swedish holding company). None of them are particularly mid-cap, but they are value plays. MID-CAP BLEND FUNDS Many funds will call themselves mid-cap value or mid-cap growth, but it's unlikely a fund company will ever market a fund as a mid-cap blend. Middle of the road in market cap without a distinct value or growth bent? Sounds like a big yawner--or a marketing challenge. But consider this: the supersized Fidelity Contrafund became a large-cap fund in 1998. Since Morningstar began tracking investment style, Contrafund has behaved more like a mid-cap blend. Still, Fidelity marketers have never presented this fund as a mid-cap, only as a "contrarian" in nature. With over $30 billion in assets, it's hard to even imagine this as a contrarian. Until 1997, Fidelity Magellan was also a mid-cap blend. After all, the fund's reputation had been built on savvy stockpicking, not stylistic purity. It makes a lot of sense that many of the funds run by star stockpickers wind up in this category--they'll go to all corners of the stock market for a good investment. And when the compositions of those portfolios are calculated, they wind up smack in the middle of the pack. Mid-cap blends are not easy to categorize, or even easy to spot. The best performer in this category over the last three years is Oak Value Fund (Table 2-11). The top fund for the 5-year period is Mairs & Power Growth Fund. The best for 10 years is CGM Capital Development Fund. Only the 1-year winner Rightime Midcap Fund even gets close to its true nature. The largest holdings of the mid-cap blend funds certainly don't look very mid-cap at all. That's because the mid-caps are often a blend of large and small, and those large ones tend to dominate such listings. The smallest company of the top 10 holdings (excluding the mutual funds) is Burlington Resources at $6.3 billion market cap, still a little too large to be a mid-cap stock by Morningstar's definitions (Table 2-12). But further down the list, in the No. 11 through No. 20 range, you find companies like Apache Corp. (an oil-and-gas producer) and IMC Global (a fertilizer manufacturer), both with $2.4 billion market caps. You probably wonder why the largest holdings of these funds include some T. Rowe Price funds. That's because the T. Rowe Price Spectrum Growth Fund--a $2.7 billion fund that invests in other Price funds--falls into this category. Another long-standing mid-cap player is the Nicholas Fund, a $5.8 billion fund run by the man whose name is on the door, Albert Nicholas. By charter, it's supposed to invest in small-cap and mid-cap companies, and it does. Many years ago, the fund had more of a small-cap cast, but with the growth in assets, the fund has tended to own some larger stocks like Berkshire Hathaway, Fannie Mae, and Citigroup. The newer Nicholas II Fund, also run by Albert Nicholas, was for years a mid-cap blend, but has crossed over to the mid-cap growth category. The Nicholas Fund has an attribute that's a little more common in this category than in most others--portfolio managers with lots of longevity. Nicholas has been running the Nicholas Fund since 1969. George Mairs has been at the helm of Mairs & Powers Growth Fund since 1980. Longleaf Partners' O. Mason Hawkins has been on the job since 1987. Donald Yacktman started the fund that bears his name in 1992. But that came after a long career running other funds, and he was no babe in the business. Mario Gabelli, whose Gabelli Value Fund was the best performer in this category in 1997, is another veteran stockpicker who was a portfolio manager for years before branching out into mutual funds in the mid-1980s. Another marathoner in this category is Kenneth Heebner of CGM Capital Development Fund. He's been running that fund for 20 years. Heebner, known for making bold bets on particular stocks and industry sectors, has excellent 10- and 15-year records. But interspersed in those years are some nasty single-year surprises. In the last two years, he lagged the S&P 500 by more than 10 percentage points, and in 1994, the fund was actually down nearly 23 percent. When big bets go bad, watch out below. Just look at Merrill Lynch Growth B. In 1996, the fund started to load up on energy stocks--especially the volatile energy service firms--in anticipation of stronger demand for oil. The bet worked for a while. But in 1998, the fund held over 50 percent in energy stocks and oil prices, adjusted for inflation, sank to levels not seen in decades. The upshot was that the fund logged a horrendous 24.2 percent investment loss, and assets dropped by another 24 or so percent as investors fled the fund. And in just one year, the fund went from C to D in its overall rating, and from A to F in category rating. (The fund, however, moved from the mid-cap growth to the mid-cap blend category during the year.) MID-CAP GROWTH FUNDS Scratch beneath the surface of a mid-cap growth fund and you may just find a successful small-cap growth fund. Many funds, of course, have long plowed the sometimes neglected area of mid-cap stocks, but they never presented themselves as such. Brian W. H. Berghuis, portfolio manager of T. Rowe Price Mid-Cap Growth Fund, recalls that when his fund started in 1992, the term mid-cap investing was barely on Wall Street's radar screen. Berghuis seized the ground because, he felt, investors could earn nearly as much money with mid-caps as small-caps but take on a lot less stock-price volatility. Berghuis's strategy is to buy the growth stocks when they are in the $500 million-to-$1.5 billion market cap range and let them roll. If this strategy is successful, they'll grow into mid-caps. If you start with mid-caps, the successful ones eventually graduate to the big leagues. There have always been mid-cap growth funds, though, even if they didn't explicitly present themselves that way. The William Blair Growth Fund, for instance, invests in growth stocks of all market capitalizations, but has always balanced the mix so that it falls smack in the middle. Many mid-cap growth funds never explicitly intended to be mid-cap. They just started as small-cap growth funds and grew into the category. That's what happened with PBHG Growth Fund. The prospectus allows the fund to invest in companies with either revenues or market capitalizations of up to $2 billion. That's the limit. Until 1995, the fund always managed to keep its median market cap well within the small-cap limits. And, of course, the fund excelled in that tough field, especially in the early 1990s. In 1991 and 1995, the fund earned a little better than 50 percent returns. But in the mutual fund business, success brings in money, and more money can lead to the inevitable "market cap creep." With more and more money, fund managers are simply forced to buy larger- and larger-cap stocks to fill the portfolio. Among those that grew into this category are Alger Small Capitalization, American Century-20th Century Vista Investors, Fidelity OTC, and MFS Emerging Growth B, the fund with the best 10-year record (Table 2-13). Delaware Aggressive Growth A, the fund with the best three-year returns, is a small fund with about $120 million in all its share classes. The fund concentrates its portfolio in just a few sectors, most recently technology, services, and to a lesser extent, financial stocks. At PBHG Growth, the fund assets grew so much it was remarkable that fund manager Gary Pilgrim could keep the fund focused on small-cap stocks as long as he did. PBHG Growth swelled to $187 million at the end of 1993 from $3 million at the end of 1992. By the end of 1995, the fund had $2 billion in assets, already a sizable fund for one with a small-cap mission. The fund had been closed for awhile in 1995, but reopened at the start of 1996, and the money rushed in again. By year-end, assets were up to $5.9 billion. After that, the fund was weighted down with money at the same time the market for hyperactive emerging growth stocks dried up. In the 1996 through 1998 period, the average annual total return was just 2.2 percent. Of course, even if a successful small-cap growth fund remains closed to new investors, it still can become a mid-cap fund by virtue of its successes. If enough small-cap stocks flourish, they eventually become mid-caps. Some managers will sell them out of the portfolio at that point, but not all. Hold on to the winners, and the fund becomes a mid-cap. It's just the result of successful investing. As is much the case with the other mid-cap fund categories, most of the largest holdings are not mid-cap companies (Table 2-14). No. 1 holding BMC Software, with a $9.6 billion market cap, actually is a mid-cap stock, and so is the No. 2 holding, Compuware. America Online was actually a mid-cap at the beginning of 1998, but has since vaulted to the ranks of the megacaps. In fact, about a third of the gain of the S&P MidCap 400 index in 1998 came from America Online. On December 31 of that year, Standard & Poor's Corp. moved AOL to the S&P 500. SMALL-CAP VALUE FUNDS When you mention investing in small companies, many people think of an Internet start-up or biotech research firms or faddish specialty retailers or fast-food chains. Consider the major holdings of Longleaf Partners Smallcap Fund, one of the best performing small-cap value funds of the last few years. Among the companies are a machine tool maker, a real estate developer, a cable TV operator, and a community bank. Hardly cutting edge stuff, no? That doesn't mean you can't make money in these stocks. Indeed, a well-run company in a prosaic business can be a big money-maker. These companies don't usually have to worry too much that their new technology will become obsolete in six months or that new competitors are opening their doors every day. That's usually not the case. Small-cap value stocks--and the funds that invest in them--often run counter to the faster-paced, highfliers that usually make the headlines. When those "momentum" stocks sputter, as they did in the second half of 1996 and first quarter of 1997, and again late in 1997, the small-cap value stocks usually pick up steam. There was no steam in 1998 for these funds. In fact, they were dead cold. On average, they ended the year down 5.9 percent. That was the worst showing of any diversified U.S. fund category. But even with a horrible 1998 performance, small-cap value funds beat small-cap growth over the three- and five-year periods. The last year notwithstanding, small-cap value funds have some advantages. Because the stocks they buy are already "cheap" when measured by traditional yardsticks like p-e ratios, p-b ratios, and dividend yields, the funds tend to be less volatile than the funds that buy the more traditional emerging growth stocks. In effect, these funds are a way to play the small-cap market without wild price swings, a more palatable way to play small-cap stocks for nervous investors. As a result, small-cap value funds have historically fared a lot better in risk-adjusted ratings than the small-cap growth funds. In the 1999 business week Mutual Fund Scoreboard, two small-cap value funds earned A's, the highest rating for risk-adjusted returns. One small-cap growth and no small-cap blend funds made it onto the overall top performers' list. Small-cap value funds can be a pretty diverse lot, if only because there are so many more companies they can invest in. Large-cap growth funds all build their portfolios from among the same 200 to 300 companies. Even small-cap growth funds tend to be duplicative in their holdings because the managers are mainly seeking the same lightning-like emerging growth companies. But in small-cap value, there are literally thousands of possible investments. That doesn't mean it's easy to invest in these companies. Many of the stocks are not liquid. That is, there's little day-to-day trading in the stocks because there are not that many shares to start with. And many of them are "closely held," that is, in the hands of a founder, some family members, or managers (Table 2-15). Because of the limitations of this corner of the market, small-cap value funds sometimes face the choice of closing to new investors or moving up the capitalization ladder. Franklin Balance Sheet Investment, Heartland Value, Longleaf Partners Small-Cap, Skyline Special Equities, and T. Rowe Price Small-Cap Value have dealt with size by closing to new investors, though in 1998, the Heartland and T. Rowe Price funds reopened as the small-cap stocks sank and their assets shrank. Given the difficulty of investing large sums in this corner of the market and the propensity for the funds to close to new investors when performance is strong, there are few megafunds in this category. The giant, of course, is Fidelity Low-Priced Stock Fund, which has been a category-beating performer of $9.1 billion girth. (Heartland Value and T. Rowe Price Small-Cap Value are the next largest funds in the category--each with about $1.6 billion in assets.) Small-cap is a huge universe of stocks, so many managers find it useful to break it into even smaller segments. Consider the Royce Micro-Cap and Royce Premier Funds. Portfolio manager Charles Royce takes distinctly different approaches to the two. Royce Premier chooses its investments from among 1400 or so small-cap companies with market capitalizations of $300 million to $1 billion. Most small-cap funds and institutional investors stalk that prey, he says, and thus it's a fairly efficient market. So with Royce Premier he makes bigger bets, limiting his holdings to about 50 companies and concentrating them in several sectors. For Royce Micro-Cap, he looks to a universe of some 6500 companies, with market caps of between $5 million and $300 million. Since this micro-market is much less liquid, he owns many more stocks--about 150--in a broadly diversified portfolio. Another Royce-run fund, Pennsylvania Mutual Fund, has a mix of the two strategies. Perhaps because this universe is so diverse, there is far less concentration in the funds' largest holdings (Table 2-16). For instance, the largest holding of the small-cap value funds is USEC, a processor of uranium fuel for nuclear reactors. It's just 0.29 percent of the category's collective holdings. (It's the second largest investment in the Fidelity Low-Priced Stock Fund, the giant in this category.) Compare that to the top name in mid-cap value, Chase Manhattan Corp., which commands 1.78 percent of the mid-cap value funds' aggregate holdings. The tenth-largest holding, Dallas Semiconductor, is about 0.24 percent of aggregate holdings. SMALL-CAP BLEND FUNDS If you are only going to invest in one small-cap fund, you may want to go up the middle with a small-cap blend fund. Some funds, for instance, build portfolios with two managers who mix value and growth plays. The value manager buys financial and energy stocks, the growth manager, consumer products and health-care companies. But taken as a whole, the blended funds tend to behave a little more like growth funds than value. So they're not exactly the same as buying 50 percent each of a small-cap growth and a small-cap value fund. Still, these funds can give investors much of the taste of small-cap growth without quite as much hair-raising volatility. The best performer in 1998, Weitz Hickory Fund, was up 33 percent (Table 2-17). Weitz Hickory is a small-cap version of Weitz Value and Weitz Value Partners, which are A-rated mid-cap value funds, though with a different portfolio manager. During 1998, Hickory's portfolio manager Rick Lawson made big gains in cellular communications and cable TV stocks, much like his associate Wallace Weitz did with the mid-cap funds. The rising valuations for these stocks also pushed the fund over the line from value into blend. If you're not already in the fund, you can't buy it. Rather than get swamped with money--and suffer PBHG syndrome--Weitz Funds closed the fund to new investors on one day's notice. No doubt that left many prospective investors disappointed, but it should have elated those already in the fund. Other funds in this category are less specific in their investment objectives. Basically, their portfolio managers are just looking for money-making opportunities in small-cap stocks. The largest holdings in this category truly are a blend of growth and value stocks, and some aren't even small-cap (Table 2-18). Philip Morris, for instance, isn't even close. The food and tobacco giant ends up on the list because it's a 5 percent holding of Safeco Growth No Load Fund. And when Morningstar analysts crunch Safeco's numbers, the median market cap of its portfolio is $728 million, comfortably in the small-cap range. Safeco Growth, the second largest fund in this category, has a heavy influence on the aggregate holdings. No. 1 holding Green Tree Financial was also its largest, though since Safeco last reported its holdings Green Tree was taken over by Conseco Corp. Chancellor Media, at $6.8 billion in market cap, is a mid-cap company and another large Safeco investment, and it's the No. 2 holding for the category. Still, half of the stocks on the largest holdings list really are small-cap by Morningstar's definition--a market capitalization of $1.2 billion or less. Safeco No Load Growth Fund is a bit of an oddball for a category in which most fund names incorporate the word "small." Safeco's prospectus makes no mention of market capitalization. It only states that the fund will invest primarily in common stocks. For the 10 years that Thomas Maguire has run the fund, he's found the good opportunities in small-cap stocks, but says he would go up the market capitalization scale if that was what it took to get good investments. The fund does have about 20 percent of its assets in large-cap stocks versus about 60 percent in pure small-cap stocks. Remember, even in a small-cap fund, managers have a lot of leeway about the companies they will hold. Some just require that the companies be small when purchased; others boot them when they reach a particular size. And some fund commentators have complained that over the last few years none too few small-cap funds bought bigger companies to enhance their returns. Purists were annoyed by that; shareholders probably were glad to have returns higher than they otherwise would have been. If you definitely want your small-cap fund to stay in small-caps, there's always the Vanguard Small Cap Index. It tracks the Russell 2000 stock index, which for many money managers is the preferred benchmark index for these stocks. The median market capitalization is $671 million, well within the small-cap parameters. While index funds have made mincemeat of most fund managers in the large-cap arena, the case for indexing among small-cap stocks is less clear cut. Active managers argue that these stocks are less efficient than big-caps and they can exploit these inefficiencies through good stock selection. The index funds say the higher costs of operating in the small-cap arena wipe out any gains from stockpicking. New research from Morningstar Inc. comes to two conclusions about small-cap index funds. During bull markets, they edge out actively run small-company funds using the same investment style. During bear markets, they lag, and their overall risk-return profiles are equal to or slightly worse than those of actively managed rivals. During 1998, which in effect was a bear market for small-cap stocks, the Vanguard Small Cap Stock Index beat about 60 percent of the other small-cap blend managers. SMALL-CAP GROWTH FUNDS Strap on your seat belt, put on a crash helmet. Small-cap growth funds are the most volatile of the nine U.S. diversified fund categories. In theory, this should be the most rewarding kind of fund. The fund managers are investing in small, rapidly growing companies. When these high-octane stocks work, they can make big, big bucks for fund investors. When they flop, by failing to meet an expected profit forecast or bungling a new product, look out below. There are few buyers for those busted emerging growth stocks when all the small-cap growth managers want to sell. So they sell what they can and mark down the rest of their holdings. Still, there's plenty of potential in these stocks and these funds because of some of the simple laws of percentages. There's no limit on how much a successful company can earn or gain in stock value. Just look at Microsoft, which went public in March 1986 at $21 per share--29 cents, adjusted for all the splits since. At the recent price of $167, that's a 57,500 percent gain. Had Microsoft bombed, the maximum loss would have been 100 percent--and fund managers hold on to a losing situation to that point. A few stocks with even one-tenth of Microsoft's gain can make a powerful impact on these funds. A small-cap growth fund doesn't have to hit a home run with every stock; a handful will more than carry the rest of the portfolio to fund stardom in any one year. This is a category where funds with small asset bases can often stun fund watchers with enormous returns. That's because a few choice small-cap stocks can really make them run. After three years in operation, Jundt U.S. Emerging Growth Fund still has only $12 million in three asset classes, which is surprising considering the performance. The fund was up 37.8 percent in 1998, benefiting from a 43 percent concentration in technology stocks and 28 percent in service industries (media, telecommunications, etc.). That 1998 showing was no fluke. The three-year average annual return is 36.7 percent, making it the best-performing small-cap growth fund for the last three years as well (Table 2-19). To invest in these funds, investors need to withstand a good deal of volatility. The Jundt fund, for instance, can really swing. Over its three-year history, two-thirds of the time the fund's monthly return has been within a range of plus or minus 12 percentage points from its average. For small-cap growth funds as a whole, that figure is about 8.5 percentage points. For an S&P 500 index fund, it's 5.9 percent. To make money with these funds, an investor needs to be able to ride out the inevitable downdrafts. Otherwise, investors end up buying after the fund has already done very well--and come to their attention--and selling out at a loss. Not all funds in this category will take your money on a wild ride. In fact, those which have earned a category rating of A--best risk-adjusted returns--have relatively low volatility and thus give good returns for the risk. Those funds are Baron Asset, Fasciano, Gabelli ABC, Galaxy Small Cap Value Retail, and Nicholas Limited Edition. Baron Asset has the highest trailing five-year returns, 19.9 percent. But it's a $5.6 billion fund, very large for this category. Its largest holding, the brokerage firm Charles Schwab, is certainly no small-cap stock today, but was when Baron bought it and held on. Since Schwab is a large holding, about 8 percent, of one of the largest funds in the category, Schwab winds up as the largest holding of the small-cap growth funds (Table 2-20). Size is starting to catch up with Baron, though, and its returns are slipping. In 1998, the fund earned just 4.3 percent, a little less than average for the category. The Fasciano Fund, on the other hand, could be the next Baron Asset Fund. It is still small, just $233.2 million, earned a 7.2 percent return in 1998, and has overall risk that's just average. (Baron is high risk.) Not bad for a small-cap growth fund at all. Gabelli ABC has by far the lowest risk of these, but while it's small-cap growth by the stocks it owns, the fund can also take steps that are different from most small-caps, like raising cash or buying debt securities. Even with a low-risk profile, the fund's trailing five-year return, 9.9 percent a year, is unlikely to get anyone excited. Many small-cap growth funds practice an investment strategy called momentum investing--buying the stocks of companies with a high earnings growth rate and great prospects that this will continue, companies with "momentum." Practitioners of this strategy don't believe in buying cheap stocks and selling them when they move up. Their game is to buy what's moving up and sell it when it moves up higher. In other words, "buy high, sell higher." The distinguishing characteristics of the stocks these funds traffic in is their high price-to-earnings ratios. They are also subject to more volatility in their performance. Among the momentum funds are AIM Aggressive Growth A Fund and the Kaufmann Fund. Kaufmann has the top return funds for the last 10-year period, but in recent years, it has had very little momentum in its returns. Kaufmann earned just 0.7 percent 1998, and has a three-year average annual return of 11.1 percent. Compare that to the 20.9 percent average return over the 10-year period and you can assume that this fund's best days are behind it. Indeed, during 1998, about one-quarter of the fund's assets departed. Not that any funds that follow small-cap momentum strategies were a whole lot better. AIM Aggressive Growth was up only 5 percent, and American Century-20th Century Giftrust Investors was down 13.1 percent. That one-time high-flier now has a three-year record of -3.2 percent a year. That's no doubt made many shareholders unhappy, and there's nothing they can do about it. This unusual fund locks its shareholders in for a minimum of 10 years.
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