A star fund manager gets fired for making unauthorized personal trades, and suddenly federal regulators are probing how managers might use funds to personally grab sweetheart deals. Seemingly low-risk bond funds buy exotic "derivatives," then crater -- some losing 25 percent -- when interest rates rise. Even some money market funds, where many people stash their safety-net money, have to be bailed out with cash infusions from their sponsoring companies. Gargantuan Fidelity Investments reports incorrect share values for about 150 funds one day when its calculations fall behind. A derivative-scarred money market fund announces it will shut down, and shareholders will get 94 cents back on every dollar invested.
What demon has gotten into mutual funds this year? Just a year ago, funds seemed like the investor's best friend, a near- bulletproof resource. Now, a parade of missteps has cast doubt on the fund industry's ability to handle the $2 trillion-plus that investors have entrusted to it. The year's choppy markets are not to blame -- most investors know to expect occasional losses. After stocks bounced back smartly in the third quarter, stock- fund investors on average were less than 1 percent in the red for the year, according to Kanon Bloch Carre, a Boston firm that analyzes fund performance (table, Page 86). Bond funds held just about steady in the quarter, a relative respite after the drubbing they took as interest rates rose in the year's first half.
It is management mistakes -- not market troubles -- that have investors questioning the fund industry's dependability. What's the appropriate response? Least worrisome is Fidelity's pricing bumble, even though it resulted in incorrect prices in the next day's newspapers. Fidelity blamed an unauthorized decision by a low-level employee. That's hardly a good excuse, but given the embarrassment Fidelity suffered, the event isn't likely to recur. The year's other troubles deserve more of investors' attention -- but take care not to overreact. Mutual funds are still a remarkably dependable, efficient way to invest, if you understand the risks. These key principles will help you choose wisely and avoid a replay of the fumbles of '94:
A money market fund is not a bank account. The mistake some money funds made, says Ralph Norton, managing editor of the IBC/Donoghue Money Fund Report newsletter, was gunning for higher yields by spiking their portfolios with derivatives that magnified changes in interest rates. ("Derivative" is a catch-all name for an instrument whose value is pegged to a benchmark, such as interest rates, currency values or stock prices.) The tactic was allowed by federal rules. But when rates shot up faster than expected, the derivatives plunged, dragging down investors' principal -- which should never happen in a money fund.
Federal regulations build some comfort level into money funds by requiring them to invest in high-quality securities with short terms or with payouts that track interest rates. Those rules should keep the net asset value constant at $1 per share. But no state or federal insurance guards your principal; no rule calls for funds to make investors whole if things go wrong. In June, the Securities and Exchange Commission issued a new list of money-fund prohibitions, including a ban on securities that magnify interest-rate changes. Some of those securities still lurk, however, because funds weren't ordered to dump them right away. To minimize risk, Norton recommends choosing a fund from a large, well-known fund company. The one money fund that failed this year was run for a small group of institutional investors -- mostly small banks -- who had little incentive to come up with the cash needed to keep the fund going. Big, well-known fund sponsors like BankAmerica and Value Line -- both of which anted up bailout cash this year -- have the incentive and the resources to come to the rescue, if need be.
But no fund company will guarantee a bailout, so call the fund and ask if it owns any of the types of securities on the SEC's new blacklist. If the phone rep can't answer, look elsewhere. Move on, too, if more than 5 percent of a fund's portfolio still includes banned securities, advises Norton. A list of funds with safe portfolios and competitive yields appears above.Derivatives can be OK. Automatically shying away from all mutual funds that use derivatives is neither necessary nor wise. "Nearly every mutual fund portfolio has some kind of derivative in it, even if people don't think of it that way," says Pamela Wilson, a mutual-fund-law attorney at the Boston law firm of Hale and Dorr. Ginnie Mae mortgage securities are a derivative, she points out. So are the foreign-currency options that can protect the value of foreign-stock holdings when currencies fluctuate.
Yet there are simply too many kinds of derivatives -- some extremely complex -- for investors to know exactly where each kind belongs and how risky it is at any given time. And the shareholder reports that funds mail to investors can mislead. What's listed as a "floating-rate note," for example, might be a plain-Jane, interest-paying corporate note that drifts serenely with interest rates, buffering the portfolio from abrupt changes. Or it might be an "inverse floater" that moves opposite to interest rates and is leveraged to boot. "In many cases," warns Don Phillips, publisher of Morningstar Mutual Funds, a Chicago fund-rating service, "even someone trying to do his homework isn't going to be able to identify what's a clean portfolio and what isn't." Last week, SEC Chairman Arthur Levitt declared that fund companies should write prospectuses and other shareholder documents in plainer language, promising expedited review for those that do.
The SEC also wants a yardstick that measures the overall risk of every mutual fund, taking derivatives into account. Gene Gohlke, head of the SEC's fund inspection program, says the agency may have a plan by early next year. Many experts are dubious. "I wish them luck," says fund attorney Wilson, "but I doubt it can be done. Risk isn't a fixed quality; it depends on market conditions." Some securities, such as start-up-company stocks, might be quite liquid in a bull market but hard to unload in a bear market. And many funds take on more risk in bull markets to pump up returns, says Kanon Bloch Carre portfolio adviser William Dougherty, "because that's when fund companies can really bring in the assets" -- and management fees.
Investors needn't just retreat into savings accounts. One way to protect yourself -- with any kind of fund -- is to watch out for performance that's way out of line with similar funds, a possible sign of a derivative that doesn't belong. The Piper Jaffray Institutional Government Income Portfolio, for example, has been slammed by derivatives losses this year, losing 26 percent through the end of the third quarter. Last year -- as interest rates fell -- the fund gained nearly 16 percent, more than twice the average for short-term government bond funds. Seldom does that kind of extra return come without extra risk.
For dependable income without extraordinary losses (or gains), bond investors should choose funds that stick with bonds and maybe a few of the simpler types of derivatives. A selection of bond funds that have performed well and avoid exotica is shown at right. And one way to insure against the riskiest stuff is to manage your own "fund" -- Treasury securities purchased directly from Uncle Sam and held to maturity. Since hitting a 22-year low last October, Treasury rates have soared. One-year T-bills, for example, now yield about 6 percent and five-year T-notes about 7.3 percent. (One-year bank CDs now yield just 4.6 percent, according to Bank Rate Monitor.) Exemption from state and local tax gives Treasuries another boost.
To buy with no commission -- which could run about $50 per transaction even at a discount broker -- call one of the 36 Federal Reserve Bank offices or the Bureau of the Public Debt in Was
