You Need to Know Your Mutual Fund

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There are some basic things you should know about mutual funds in general and about the specific fund in which you are about to invest. Mutual funds with a bad track record are dissolved.

The fund assets are absorbed by another fund and the fund manager is given a new fund to manage. Also, an average fund manager has limited experience.

A mutual fund company does not want to keep a poorly performing fund in its fund family for very long. A poor performer brings down the average performance of its funds. Also, when the financial media makes comparisons between funds in the same fund category, new assets go to the best performer rather than to one near the bottom of the list. For example, if you were looking at the relative performance of 50 large-cap growth funds, and saw that fund ABC returned an average of 19% a year for the last 5 years and that fund XYZ had lost 2% a year over the same period, where would you invest your money? The company that owns XYZ would not be blind to the fact that their offering in that fund category is not attracting new investors and that it is likely to lose the investors it already has.

The company would want a stronger and more attractive offering in that fund category. Therefore, after a few years of poor performance, the poorly performing fund will disappear completely as the fund is dissolved and its assets are combined with those of another fund. The fund manager will often be given another fund to manage. If you are an owner of shares in the receiving fund, your account will receive the toxic assets transferred over from the poor performer. Your fund manager will then try to unload those assets quickly.

When the poorly performing fund vanishes, the average performance of the funds in the family increases. The toxic assets are placed in a larger fund where they are less conspicuous and they are sold off quickly so that they simply add assets to the receiving fund. They do no harm to the receiving fund (they actually serve as a bonus to that manager), and they no longer harm the reputation of the company.

On the other hand, you may have bought a small fund that has performed very well for three years. The company that owns the fund will want to place that manager in a more conspicuous place so he can attract more money to the fund family. It is in the company's best interest to promote the manager by rewarding him with a larger fund to manage (and with a bigger paycheck). Your fund may then end up getting the manager who performed so poorly that his fund was buried to save face for the fund-company. If you follow the high-performance manager to the new fund, you may discover that he cannot perform as well as he did before because of the larger size of the fund. However, he will probably do a better job than the poorly performing manager you would have inherited had you stayed put.

Keep this switch and merge procedure in mind when you compare the performance of mutual fund

families or when you read in the financial press that the average growth fund had a return of 18% last year. The average given is always skewed by the fact that the poor performers have been eliminated so that their performance is not counted in the averages. Poor performing managers are switched to smaller funds that have such a good track record that their managers were given a larger fund to manage. New investors may be buying shares in the small fund because of the performance achieved by the manager who has left. They are not aware that the fund has a new manager whose prior performance was an embarrassment to the company. The performance of that once spectacular smaller fund may now take a dramatic downturn.

Without some real digging on the part of the investor, it is difficult to know whether the performance of a fund over the last ten years was really due to the efforts of the current manager.

Stockdisciplines.com is no longer managing accounts for people, but one of my duties when they were in the business was to call mutual funds and ask a lot of questions. When a star stock-picker leaves, investors often try to follow. Funds do not like to lose assets. Therefore, I noticed that over the years more and more funds claimed that the "manager" is a "committee." I found that fund management increasingly assigned a committee to work under the star stock picker. That way, when a top performing stock-picker left, he or she is replaced, but "the same committee still manages the fund." This reduced transparency, but the funds kept accounts that might otherwise transfer. To the best of our knowledge, this practice has continued to expand throughout the fund management world. Funds will try to capitalize of a star performer's celebrity until he or she leaves. Then the emphasis becomes "the same committee is managing the fund that has always managed the fund." Though individuals come and go, the committee remains.

The problem here is that committees never perform like a star stock-picker. They cannot because committees represent the best thinking of a group of people. What makes a star performer a "star" is that his picks are better than average by definition. His picks and his timing are outstanding, and are not the result of "group-think." This trend toward management by committee is an illustration of how mediocrity is triumphing in the fund business as excellence takes a back seat to a fund's desire for the long-term retention of assets. Think of it this way. In a class of 100 students, perhaps 5 will achieve a level of excellence that will mark them as outstanding achievers. In any class, only a few can be outstanding relative to the others in the class. If 50 students not included in top 10 of the class combined their talents to write an essay, the end result may be a good essay, but it will not be as good as that of the top achiever in the class. Funds try to promote the idea that many heads are better than one. Though the idea seems logical on the surface, it is not true. Though it is true when it comes to something like physical strength, it is not true when it comes to creativity or genius. Fifty thousand average thinkers would not be able to combine their intellectual resources to come up with the theory of relativity. Here, the one is greater than the many.

The bottom line is that extreme care should be exercised before placing your hard-earned money in a mutual fund. Call the fund and ask for its performance history. Be specific. Ask for the total return, the capital gains distribution and income distribution for each year for at least 5 years. Try to determine how often the manager is replaced and when the last change was made. Simply ask who the previous manager was and when he or she left. Then ask who the manager was before that and when that manager left. Be sure that with all your questioning you find out who the current lead fund manager is and how long he or she has been in that position. If the manager has not been there at least five years, ask which funds he or she managed before. Go to the library and check the performance of those funds during the time that manager was in charge (Morningstar is

a good resource for this). If the fund is managed by a committee do not expect outstanding performance. On the other hand, average performance may be preferable to that achieved by a manager about whom you know nothing.

Copyright 2009, by Stock Disciplines, LLC. a.k.a. StockDisciplines.com

Dr. Felt has current market reviews, stock alerts, and free tutorials at http://www.stockdisciplines.com Information and videos about stop losses are at http://www.stockdisciplines.com/stop-losses

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