This is shaping up to be the worst year on record for the fund business. What went wrong–and how you can ride it out.
By David Rynecki
(FORTUNE Magazine) – Fund managers are supposed to be the big kahunas of finance–deftly maneuvering billions of dollars through the ups and downs of tumultuous markets, keeping your money safe, making you rich, no matter how rough the waters. After all, that’s what they’re paid for. So how do you explain the total wipeout that 2001 is turning out to be?
Consider these facts: The $71 billion Fidelity Magellan fund–down 17.4% for the year; the $27 billion American Century Ultra fund–down 22%. Big- name, big-money funds are sinking along with just about everyone else. Entering October, the average U.S. equity fund had lost 22% on the year–and was headed for the worst annual performance on record, according to research firm Lipper, which has tracked the fund industry from its infancy in 1960. In the third quarter alone U.S. equity funds plummeted 18%, compared with a 15% drop for the S&P 500. An incredible 99% ended the quarter in the red. Many funds that were supposed to have the ballast to weather any storm are under water. Large-cap “value” funds–which allegedly buy cheap blue chips–are off 14.6% year to date. And “balanced” funds–which can invest in bonds!–have dropped 10.3%. All of which raises serious questions about the relevance of actively managed funds. Says Robert Markman, a financial advisor who runs funds of funds and who himself was caught in the downdraft: “I’ve got clients wondering why they should give money to some portfolio manager who will lose 60% when they could do that all on their own and still have time to mow the lawn.”
Point taken. Indeed, how is it possible that so many funds in so many categories look so pitiful? Sure, there have been noteworthy standouts among value funds, as well as those specializing in energy, defense, and real estate. And some veterans, like Marty Whitman at Third Avenue funds and Wally Weitz at Weitz Partners Value, are doing yeoman’s work once again. But with the vast majority sinking well below the averages–what, exactly, are you paying for?
With that question in mind, FORTUNE set out to examine the reasons for the broad decline in funds. This requires taking a step back into the bull market to a time when everything looked easy, when the Street was thick with geniuses, and a bad year meant a 20% return.
First, consider the people in charge of your money. Most were in diapers the last time we saw anything like a real bear market–the nasty, stagflated, oil-shocked early ’70s. Like the children of the Great Depression who pinched pennies even during prosperity, the generation running money today is a product of its environment–one in which stocks did nothing but go up. They embraced simple adages–”Buy on dips,” “The trend is your friend”–because they worked! The 1987 crash came to be viewed as the ultimate buying opportunity, the savings and loan crisis was a blip on the radar screen, and the 1998 Asian crisis was a chance to purchase cheap tech stocks before they really took off.
No firm embodied–and propagated–this go-go growth culture more than Janus. The Denver boutique tended to hold concentrated positions in high-P/E, high-growth stocks, usually media and technology companies. Through 1999, eight of nine equity funds at Janus clobbered the S&P 500 for five consecutive years, with an annualized performance for the entire group just shy of 35%. The Janus school of thought prized hot concepts and the potential for growth over traditional measures like price/earnings ratios. Stocks like Cisco and EMC, the managers believed, would eventually fit into their valuations much like a toddler filling out a pair of shoes. Investors loved the strategy, primarily because it made so many of them so rich. Soon they began pulling money out of value funds and even other growth funds and dumping it into Janus. Inflows ballooned by more than $30 billion in the first quarter of 2000 alone–a staggering 40% of all new money invested in funds–pushing the company’s total assets to more than $300 billion. “Janus was one of the only companies able to consistently deliver above-average returns year after year,” says fund consultant Avi Nachmany at Strategic Insight. “That message had nothing to do with the price level of Nokia and everything to do with the experiential side of investing.” In other words, it felt good to get rich!
When the market began to slide in March 2000, few growth managers seemed to worry. At the time Janus stock pickers told FORTUNE that, even as their core funds had fallen 20% to 30% in a matter of weeks, they were deploying fresh reserves to the “battered” tech sector. “The fundamentals remain awesome,” Blaine Rollins, manager of the flagship Janus fund, declared. Some 19 months later, Rollins’ fund has dropped 55% and other Janus funds are at the bottom of the pack. Rollins defends his stance, insisting that over the long term, investors have been rewarded. “The difference today versus two years ago,” he says, “is that today strong fundamentals alone don’t equal a rising stock price.”
What’s important here, however, is not just the outcome at Janus, but how Janus influenced the industry. At the core, the fund business is about gathering assets, not performance. Managers are paid based on the size of their portfolios, which generate management fees and loads. This creates a clear incentive for managers to give the people what they want–i.e., whatever style of investing is working at the moment. Which is exactly what happened as Janus became the trendsetter. Some firms simply copied the seemingly foolproof Janus formula. More than 34 “focused” funds sprang up between 1998 and 2000, Morningstar reports.
Other funds, though, weren’t so overt in their homage to Janus. Rather than start aggressive growth funds, some erstwhile value investors began to buy the same stuff and call it something else. Thus, the “style drift” that has become so endemic in the fund industry. Bill Miller, for example, runs the Legg Mason Value Trust fund. Among his top holdings in the late 1990s: Dell and America Online (now AOL Time Warner, parent of FORTUNE). While those are hardly the typical value stocks, they helped Miller maintain his stellar record. His 48% gain in 1998 and 27% in 1999 redefined value investing and persuaded others who watched Legg Mason’s assets balloon to do the same.
In some ways, managers couldn’t afford not to. Consider what happened to those who resisted–like Robert Sanborn, a onetime star value hunter at the Oakmark fund. Through the mid-’90s, he turned in annual gains five times that of the S&P 500. Then, in the late ’90s, his style–buying low P/E stocks with decent profit growth (Mellon Bank and Philip Morris, for example)–fell from favor. In 1999 he lost 10%, and investors headed for the exits. Sanborn came under intense pressure to buy the tech-era “values.” He refused. In March 2000, he lost his job–just days before value stocks went on an extended tear.
Of course, as Sanborn’s traditional brand of value roared back, the style-drifters who had loaded up on growth stocks were clobbered. In 2000 the Legg Mason Value fund fell 7%, compared with a 6.5% gain for the average value fund. This year it’s off 15%. Legg Mason is by no means alone: The Dreyfus Founders Balanced fund, for example, switched managers in December 1999 after Brian Kelly was deemed too conservative. The new manager, Curt Anderson, went whole hog into Nokia, EMC, and others just as tech stocks peaked. The fund is down 18% this year. Ditto at AXP Mutual: It hired a new manager in June 2000, who moved into Intel and JDS Uniphase. “They switched to growth just as growth topped out, and missed out on the value performance of the last two years,” says Russ Kinnel, Morningstar’s director of research. “The result was certainly awful.”
Awful–but far from unusual. And that seems to be the key. The deep, dark secret is that most fund managers don’t want to be different. If they’re seen as having “tracking error”–a divergence from a particular benchmark–they’re questioned about the disparity in performance. Given that only a third of funds top the index in a given year and rarely repeat the feat, the best way to match the index is to become the index, which itself is no guarantee of safety. “The guys at S&P kept putting more and more aggressive companies in the index, like JDS Uniphase, and that just added to the risk,” says Jim Barrow, managing partner of Barrow Hanley and a die-hard value investor. “Because so many funds were becoming closet indexers, you had everyone out there owning the same stocks and no one caring about growth rates, because they had to keep up.” Indeed, browse the holdings at the biggest growth and value funds. What pops up are huge stakes in Cisco, Dell, Microsoft, Motorola, and Intel. The difference between many funds is in name only.
For investors, owning closet-indexers is potentially as costly as investing with style-drifters. After all, why pay for someone to attempt (and potentially fail) to mimic the index? It’s probably worth a look: Are the top holdings in your fund also the biggest companies in the S&P 500? If so, you’d probably be better off simply buying an index fund.
As for the fund industry, there’s no evidence that the lousy performance of 2001 has spurred change, or even much soul searching. Since the market began to crumble, 30 new “value” funds have sprung up, and fund complexes that used to keep their fixed-income managers locked in the basement are thrusting them to center stage. Investors, who’ve just learned firsthand the damage that style-drifting, performance-chasing fund companies can inflict, may want to take a second look before jumping on board.
