FSO Editorials "Declining Mutual Fund Assets" by Robert B. Gordon, Sc.D. 11-09-2002

In my prior essay "Mutual Funds in a Death March" I have written about the many past and present problems in the mutual fund industry. This essay will serve to update my earlier views and proceed to discuss what could be the most serious problem confronting this huge industry.

During the years of the great mania from 1995 to 2000, the main goal of nearly every fund manager was to beat or match the record of their competitors, not to protect the assets of their clients. No one bothered to criticize these short-sighted actions while the market was going up and very few voices of protest have arisen so far in the grueling bear market.

Amazing to this long term observer of the mutual fund scene is that the mutual fund industry has continued since the market peak to manage its assets to beat the industry performance averages for each type of fund, not to prevent losses in client assets. I have not bought the very weak argument that funds are obliged to follow the objective stated in their prospectus. They do not have a mandate to watch their client assets go to near zero and they may some day have to answer in court for their failure to preserve capital.

One might possibly argue that fund owners have had the right to sell their fund shares at any time to protect their assets. It's true that a few seasoned investors like myself did sell, but the millions and millions of new investors were convinced to hold for the long term by the misleading "buy for the long term" arguments of virtually every Wall Street spokesman.

One of the better performing mutual funds until early this year is feeling the pain of redemptions. I sold my shares early this year when the small cap funds went into their bear market. Here is their recent letter:

Dear Wasatch Funds Shareholder:
Wasatch Funds is pleased to announce the re-opening of the Wasatch Small Cap Value Fund. The Fund will be available to all investors as of November 13, 2002. The Wasatch Small Cap Value Fund is being re-opened because its assets have reached a level where the manager believes that additional assets will be beneficial.
-- Eric D. Johnson, Director, Mutual Fund

I'm sure that many other funds, closed by a huge influx of money during the boom, will be writing similar letters to their shareholders. The huge mutual fund selling machine is running out of buyers as indicated by these recent press reports.

"Published: November 5 2002: The bleeding at US equity mutual funds has slowed, but not stopped, after five months of big outflows. According to early estimates by Merrill Lynch, investors took about $20bn out of U.S. equity funds in October, and there are signs that there will be further outflows in November.

October marks the first five consecutive months of outflows since the Investment Company Institute began tracking fund flows in 1990. The five-month total outflow is $109bn in net cash outflows, or 3.3 per cent of total mutual fund assets at the end of May.

The September outflows of $16bn, include $4bn from US domestic funds, and came as the S&P 500 index slumped 11 percent in that month.

Investors pulled $52bn out of US mutual funds in July, the largest monthly net outflow in history, according to fund trackers, and there have been no real signs so far that investors will jump back into the market. Investors remain turned off to equity funds at the start of November.

Some mutual funds have been hit harder than others by big redemptions. Among the worst, Janus equity outflows rose to $1bn in September, from $800m in August. Janus funds are mainly growth oriented and that style is out of favour. Fidelity, the number one US mutual fund company, has not been exempt from the pain. Fidelity's active equity funds showed another $2bn net outflow in October, and $8.7bn in 2002, while its indexed funds had a net inflow of just $61m. Fidelity's star fund, the Magellan fund, has had outflows of close to $4bn in 2002."

Bill Fleckenstein, my favorite market expert/hedge fund manager, has recently shot a few darts into the great mutual fund mystique in his current issue of Contrarian Chronicles. Read his wise words:

When marketing masquerades as investing, those who bray loudest about economic recovery typically have something to sell. But remember, they're not gambling with their own money. They're gambling with yours.

The kiddies may have just removed their Halloween masks, but on Wall Street, disguise works year-round. Corporate chieftains are still out there spinning bad news into good news. In tech land, DRAM prices rise because of a manipulation dressed up as increased demand. And under the guise of helping clients, the people who play with other people's money turn trust into losses. Unfortunately, that deception is no illusion.

Suffice to say, these results are not a sign of economic strength (though as I mentioned, the data are volatile), and that brings me to my concern for people who pay today's prices for securities. Their implicit assumption is that the economy is in the process of getting better. As I have repeatedly stated and tried to cite evidence to back it up, my belief is that the economy is getting weaker. That, coupled with current stock prices, is a recipe for huge trouble all over again.

This leads us to another source of trouble -- the credit area in general, where I believe that potential problems in credit insurance are another time bomb that's not been talked about in the popular press. A lot of people who own bonds think they are safe because they have credit insurance. I don't believe that the people who issue this credit insurance could handle a lot of things going wrong at once, which could easily happen.

That translates directly to potential problems in money-market funds. A recent story in The Wall Street Journal titled "Money Funds Slash Their Fees to Stay at $1 Net Asset Value" talks about low yields and people cutting costs so they won't have to "break the buck." Also, potential credit problems could find their way into money funds. I myself refuse to own a money-market fund unless it is a government-only fund. I think other people should give up that minuscule yield and do the same. It's not worth taking the chance. I am not saying that anything will go wrong, but for safety's sake, who cares about maximizing yields at these levels?

Returning to my rant about Other People's Money (OPM), I'd like to talk about a recent story in The Wall Street Journal titled "Rally Aside, It's a Hard Sell in the Heartland." This shows the lengths to which investment marketers will go to try to keep people in the pool (though mutual-fund manager Peter Zuger, who is profiled in the story, deserves credit for at least taking the trouble of meeting face-to-face with concerned shareholders). The problems they've been having is shown in a comment by one woman who attended a dinner for mutual-fund investors, and I think it sums up the change in attitudes rather nicely: 'There's a time when you just don't feel comfortable anymore. It's what all the other investment people are saying -- 'stay the course, keep putting money in because prices are low.' I'm not sure it gives me much assurance.'

Well, it shouldn't give people much assurance. Prices may be down a lot, but as I've said repeatedly, there's a big difference between low and down a lot. Low implies a cheaper price relative to some tangible set of fundamentals that indicates you're getting a bargain. That is not the case, though the illusion of it comprises the main reason for people chasing this rally. They think it's the bottom. Stocks have been down so much. They've been down so long. It's a good seasonal period. Any of those arguments sound like things are cheap? If the market weren't dominated by people using other people's money, and people only invested their own money, it's quite obvious to me that prices would be dramatically lower.

In any case, part of what's wrong with the investment-management business is that it's not the investment-management business -- it's largely the investment-marketing business. Things have been set up for marketing. Think about it. The mutual-fund industry has created a million different ways to package a portfolio to prospective clients, and there are too many funds out there trying to sell them. There's small-cap value, large-cap value, small-cap growth, large-cap growth, etc., as well as many other little niches used by marketers. Some of these distinctions matter, but many of them do not. Some, in fact, are just oxymorons. Consider the category "large-cap growth." By the time you get to be a large cap, for the most part, your business is going to be much more cyclical. There are exceptions to that rule, pharmaceuticals being the most obvious.

But when it comes to the investment-management business, genuine concern about losing money takes a back seat to concern about missing the next rally. As a mini-expose, I'd like to share three reader e-mails from my daily column on RealMoney. The first is from a man whose stock market losses have awakened him to the link between marketing and the people who play with other people's money:

"It's sometimes frightening how close to home our articles are. I just got done reading your Market Rap from today, and then made the mistake of checking my brokerage-account activity. Wouldn't you know it, my large-cap growth account shows that they bought a bunch of Applied Materials today."

He continues: "I would normally be upset, but it's gotten to the point where I can only laugh. (I'm still reeling from last week's surprise of seeing that my large-cap-value account manager bought a ton of Xerox. What's even funnier is that I'm up 4% for the year on the money I'm managing myself. I sometimes wonder why these money managers are getting paid five times my annual salary.." Obviously, this e-mail begs the question of why this gentleman has these people managing his money at all.

Next, we'll hear from a pension-fund consultant whose comments are a ringside seat into the world of OPM:

"I work for a pension-consulting firm. We consult to large DB (defined-benefit) plans, public plans, and endowments/foundations. At the firm, my job is to perform due diligence on investment managers. All day long, I get to listen to people tell me, 'Well, this benchmark, which for some reason we choose to mimic, lost 30%. W lost 20% this year. However, we stayed true to our style (large-growth, mid-value, blah, blah, blah). Therefore, we've done a good job.'

"It makes my blood boil. For most of these clowns, their true style is losing my clients' money, year after year after year. I think our clients are naive. And for that, I'm eternally grateful. If I were in charge of a large pension fund and somebody came to me with those results, I'd beat them senseless. Nonetheless, our clients buy into this 'style purity' bull that my firm, and my industry, propagates. So long as the managers stay close to the benchmark, they won't get fired. Someday, someone will pull the wool from their eyes and we'll get fired. I hope it happens in my lifetime, but I'm not holding my breath."

He concludes: "They buy Intel, KLA-Tencor and Applied Materials because their mandates require exposure to the 'major' sectors of the index. They can't go back to their clients and say, 'Well, friends, the outlook is apocalyptic, but we are prohibited from holding cash and from exiting sectors, so we buy the stocks that we think will take the smallest hit.' In conjunction with that, they concoct a fundamental story to justify their decision. All you can do is laugh. The worst part is that these same people manage money for retail investors, using the same philosophy and process. Too bad we retail investors don't have any way to make amends for being 'underfunded' as a result of lousy performance."

"A casual friend of mine is a physician who retired five years ago with $2.4 million. He has been calling me over the past six months, slowly revealing a heartbreaking story. He asked me how I have been doing in the market, and I replied that my short sales have been doing wonderfully. After speaking at length, he revealed that his broker at Morgan Stanley Dean Witter has kept him fully invested in aggressive-growth mutual funds and tech. His $2.4 million is now $0.8 million. He has to put his dream home up for sale, and may have to go back into practice at the age of 67."

He continues: "I replied that I thought the actions of his 'personal friends' at MWD bordered on the criminal, for not having fixed AAA fixed-income, or just anything other than what he has. Each time he would go to their office to speak with them about his portfolio performance, they would pull out all their charts and cajole him into hanging on just a while longer with the turn just around the corner. With his comfortable retirement in shambles, he is a nervous wreck. Insomnia and stomach ulcers rule his life." Obviously, this unfortunate gentleman is not without some responsibility, as he watched his portfolio melt. But this kind of thing has happened all over America.

The news has been filled lately with horror stories of the problems from shrinking corporate pension funds assets. Lured in the mania to increase their stock holdings vs. bonds, most large companies now have to repay their recent asset losses by taking funds directly from their net income to replenish the pension assets. This will not be easy in a bear market in stocks and will be almost impossible if the bond market ends its 21 year bull market as it may well do. Still worse, no institution to my knowledge possesses the ability and experience to withstand several more years of a declining market. This does not bode well for retirees dependent on pensions from corporations and state governments or annuities from an insurance company or charitable foundation. Only Social Security benefits enjoy a printing press to guarantee their future payments.

Historically, all large institutional funds held by pension funds, endowment funds and certain insurance company reserves have relied on stock and bonds to grow their assets. Our country has never seen a bear market of this magnitude and duration since that of 1929. There is no recent experience on the urgent need to conserve capital. If the institutions try to stem their huge losses in assets by turning themselves into the equivalent of a Money Market Fund, their income flow will be inadequate to meet their requirements for pension, annuity and other payments.

Just like the large institutional funds described above, equity and bond mutual funds have no serious place to put their trillions of dollars of client assets except in the traditional stocks and bonds where they have been for decades. They may not yet realize their problem because their bullish attitude still blinds their view of what is now happening. But sometime in the next down-leg of this bear market they will wake up and realize their very unfortunate and serious predicament.

Whether they realize it or not, there is no safe haven for assets in traditional giant-size mutual funds except short term debt instruments which produce little income at this time. The big funds cannot use precious metals or short funds because they can only accommodate a relatively small amount of assets in the billions, not trillions of dollars.

Few people are alive today to recall the sad fate of the mutual funds that were heavy participants in the bull market of the 1920's. Only one or two of those funds, then called investment trusts, were able to survive the 1929 Crash. In the more recent 1973-74 bear market, some popular mutual funds dropped 70 to 90% while the major averages were down about 50%. Some very speculative funds never got to the 1970's and had to liquidate their assets in the Go-Go days of the mid 1960's with huge shareholder losses.

Will nearly all equity and bonds funds in existence today disappear in today's bear market or turn into money market funds to survive? Due to their unprecedented size and influence in today's financial arena there is no answer to that question. The Fed and Treasury would try and mitigate a major crisis, but I have not ideas on what form it might take.

Since the question of mutual fund asset survival is unanswerable, the best protection any investor can have is to be sure that all their mutual fund money is in the very few ultra-safe asset classes we will present later.

Market experts whose opinions I respect, expect this bear market to eventually go much lower and to have some sort of an initial bottom in year 2004. Some time in the next two years, I believe that massive redemptions will occur in equity mutual funds. My view is that this will happen irrespective of whether stocks have a major panic-like drop or continue in a slow grinding decline. As the economy continues to decline and consumer confidence continues to fall to new lows, I see the following effects in the mutual fund industry:

Despite the problems mentioned above, I am reasonably confident that the very large mutual fund companies will somehow survive the worst effects of the stock market and economy. I am much less confident about the status of the many billions of dollars of client assets under their care.

I spend a lot of time studying mutual fund performance on my computer screen and reading reports of the fund industry and individual funds. I regret to report that I see no signs of a change in the current disregard for the safety of client assets. What I do see is plenty of fund categories in typical bear market price declines, interrupted only by the occasional bear rallies.

The only fund equity classes showing steady bear market gains are the gold funds and the short funds. The REIT funds have done quite well till recently as have a number of bond funds, but they are both subject to any adverse interest rate changes. I continue to suggest a very high allocation of assets to short to intermediate term U.S. Treasury bonds with modest allocations to precious metals and short funds.

Small portfolios must of necessity be restricted to the principal asset classes, but larger portfolios should be widely diversified into the available sub-classes as shown below:

MAJOR CLASS	% RANGE	SUB-CLASS	% RANGE
Short/Inter Govt. Bonds	50-90%	U.S. Treasury	25-45%
		Foreign Govt.	25-45%
REIT Stocks, Funds	0-10%	Diversified Fund	0-5%
		Selected Stocks	0-5%
Precious Metals	0-20%	Gold/Silver Bullion	0-5%
		Precious Metals Fund	0-5%
		Gold Stocks	0-5%
		Silver Stocks	0-5%
Short Mutual Funds	0-20%	Reverse S&P 500	0-5%
		Reverse NASDAQ	0-5%
		Fully Managed #1	0-5%
		Fully Managed #2	0-5%

For large portfolios we suggest an equal weighting of U.S. and foreign government bonds to protect against a potentially serious drop in the U.S. dollar vs. other currencies. We also suggest further diversification as indicated above in the other major asset classes.

New and old readers are urged to visit www.freebuck.com and go to the Commentary Section which archives all 57 of my essays on various subjects. From our reader e-mails we know that this wealth of information is useful for both new and seasoned investors. For further suggestions on some conservative bear market portfolios please read the following recent essays: