When funds can't be judged by their name
Here's a question: When is a large-company stock fund not a large-company stock fund?
Answer: When the name of the fund is misleading.
It's a dilemma many investors face when they look for a mutual fund that's in sync with their asset-allocation strategy.
The problem used to be widespread, until the Securities and Exchange Commission (SEC) cracked down in 2001 and required funds to keep 80 percent of their money in assets that reflect their names.
Still, experts caution, investors should keep a close eye on the remaining 20 percent, which can push a fund into unexpected areas. That 20 percent gives a fund "a lot of flexibility in terms of a manager being able to move the portfolio one way or the other," says Paul Merriman, president of Merriman Capital Management in Seattle.
For example, some managers might use the 20 percent to gain a competitive edge or to take on more risk than investors expect from the fund, says Bernard Keily, a financial planner in Morristown, N.J. "A large-cap fund might want to incorporate up to 20 percent small caps into the portfolio mix if large caps aren't hot at that moment," he says.
That's not necessarily bad, if the fund's primary sector is falling out of favor. For example, managers might increase their fund's holdings of cash or bonds if they think stocks are becoming too risky.
When the stock market is unstable, this could be a good situation for the fund, provided the 80 percent rule isn't violated, the strategy is spelled out in the fund's prospectus, and "they don't put the 20 percent in something really high risk or off the wall," says Russell Kinnel, director of fund research at Morningstar Inc., a Chicago firm that tracks mutual-fund performance.
The question is whether that flexibility fits in with one's overall strategy. Do you want full exposure to a certain sector at any and all costs? Or is performance more important, no matter where that might take your investments?
If a fund doesn't seem to be following its stated strategy, take a closer look at its holdings, Mr. Kinnel suggests. Morningstar's website (www.morningstar.com) has tools that allow investors to break down a particular fund's portfolio by sector, market capitalization, and valuation.
"We have a category based on what the fund owns, not what the name says," Kinnel says. "That can be very instructive. You can look at the holdings to see if they're sticking to their knitting."
Another cause for concern is fund names that are too vague or ambiguous. Titles such as "growth," "capital appreciation," or "growth and income" have almost become meaningless, according to Mr. Kiely.
Other problematic words might include "income" and "global," or adjectives such as "integrity" or "aggressive," Kinnel adds.
"Global" funds, for instance, are supposed to give investors exposure to a broad range of markets around the world, including the United States. But some global funds have very little exposure to stocks outside the United States.
The AXP Global Technology Fund, Kinnel points out, had 88 percent of its assets invested in US stocks in late March, while 79 percent of the Merrill Lynch Global Technology Fund was invested in the US. He also recalls one fund that included the words "government," "global," and "dollar" but was, in reality, an emerging-markets bond fund.
The SEC monitors funds to see if they are adhering to the strategy stated in their prospectuses. If they are not, the commission will send a letter to the company asking it to explain any discrepancy, says John Heine, an SEC spokesman. In most cases, this takes care of the problem. The SEC can also take civil action against fund companies that are not in compliance, although it has not had to take this step so far.
Investors who do not feel they are getting satisfactory answers from a fund company can contact the SEC. "We appreciate any comments they send our way," Mr. Heine says.
Kinnel also suggests taking a look at the fund portfolio in the most recent annual or semiannual report to shareholders, and then comparing the holdings with the strategy outlined in the prospectus. "See what's in there, and ask if it meets with what you thought was in there," he says.
Fund companies, however, have up to two months after the reporting period to mail these reports to shareholders, so the list of holdings may be out-of-date. Currently, the SEC is moving ahead with a plan to require quarterly disclosure of fund holdings, which should help investors with their asset allocation.
"What you really want to avoid is when three of your funds all do the same thing," Kinnel says. "All of a sudden, you've gone from this diversified portfolio to a real mess."