Is your fund running you?

You're investing long term. Most fund managers aren't

BY STEVEN D. KAYE

You're a mutual fund investor who has absorbed Wall Street's tried-and-truisms. You know that chasing the hot investment of the month is a loser's strategy, so, as the fund companies recommend, you don't jump into and out of investments. No, you are determined to be like legendary investor Warren Buffett, making time and patience your greatest tools.

It's a good plan, but don't expect your mutual funds to help you achieve it. With most funds, a typical stock spends barely over a year in the portfolio before getting tossed. That's hardly Buffett-like. And because of this restless turnover, concludes a study soon to be published by Morningstar, the Chicago fund-rating firm, many of the fruits of shareholders' patience are being lost--to trading costs, to higher taxes, and to the wrong-way turns of insecure fund managers. You may well ask: In what sense are you a long-term investor if little of your money is put to work long term?

Portfolio turnover isn't a subject much discussed by fund shareholders. It probably should be. By now, it's become axiomatic, if puzzling to many investors, that most stock funds don't match, let alone beat, the return of the stock market. One reason is that funds have to charge their investors for expenses from salaries to printing costs to advertising. But most funds also seem to have managers with toddlerlike attention spans. The average diversified stock fund has a turnover rate of 78 percent--that is, more than three fourths of the stock shares owned on January 1 of a typical year are sold by December 31 of that year and other shares are bought in their place.

That's just the average. The turnover at many funds--even huge ones--is even more frenetic, exceeding 100 percent. At the $17.5 billion Janus Fund, for example, the turnover rate last year was 104 percent. The rate at the $11.3 billion AIM Value Fund was 126 percent. And at the $11.1 billion Fidelity Blue Chip Growth Fund, it was 206 percent: During the year, every share of stock, on average, was sold and the proceeds used to buy new shares, then the new shares were sold, and a third shift took their place.

Turnover rate alone doesn't tell you exactly how much the portfolio has changed, because a manager could hold some stocks all year while trading others more than once, called "trading around the core." But in general, the higher the turnover rate, the greater the emphasis on short-term strategy. "Nobody would advise individual investors to sell most or all of their stocks every year," says Morningstar President Don Phillips. "Yet nearly all of the professional fund managers seem to practice that."

Good intentions. The obvious cost of high turnover is the trading commissions that eat into returns. Heavy trading could still be a benefit, though, if managers could time the short-term ups and downs of the stocks they hustle in and out of their portfolios. They generally can't--but they keep trying. "Fund managers tend to buy stocks like people get married," says Pamela Wilson, an attorney with the fund consulting group at Hale & Dorr, a Boston law firm. "They don't intend to get divorced. Then something better--or something that seems better--comes along."

Breaking up is expensive for reasons besides commissions. In its new study, Morningstar divided domestic and international equity funds into four groups by turnover rate, then plotted the average total return for each group over the past 1, 3, 5, 10, and 15 years. For every group of funds and for all but one time period, the higher the turnover rate, the lower the return. Over the past year, for example, funds with a turnover rate of less than 20 percent gained an average of 12.7 percent, while funds with turnover rates from 50 to 100 percent--close to the industry average--gained 8.7 percent. Over 10 years, funds with turnover rates exceeding 100 percent gained an average of 158 percent; those with turnover below 20 percent gained 182.2 percent, a difference of $2,420 on an investment of $10,000. (In the 10-year period, funds with 50 to 100 percent turnover edged out funds with 20 to 49 percent turnover by 0.2 percentage point per year, deemed an insignificant deviation from the study's findings.)

Tax bite. Not only do investors in high-turnover funds pay the tab for all those stock transactions but many also are hit with higher taxes. When a fund sells a stock at a profit, shareholders are liable for taxes on the capital gain this year, not in some later year when they might sell their fund shares (unless, of course, shares are held in a tax-deferred retirement account). That makes the high turnover in most funds even less desirable, because tax deferral, one of the main advantages of owning stocks, is compromised.

Consider two funds that have made similar gains recently: the Fidelity Blue Chip Growth Fund and the value-oriented Torray Fund of Bethesda, Md. Both funds buy mostly large-company stocks--Philip Morris, IBM, Johnson & Johnson, and Citicorp have recently been in both portfolios--along with some smaller companies. Fidelity Blue Chip Growth's managers have tended to buy more technology stocks; the Torray Fund, run by Robert Torray, leans toward financial stocks. But whatever differences there have been in stock selection, each fund has gained an average 18.9 percent per year over the past five years. That beats the S&P 500-stock index's 17.1 percent annual return over the period, an admirable feat.

That's what the funds have gained, not the people who invested in them. At Torray, where the basic strategy is to buy a stock when its price has dropped and then hold it for at least several years (box), the turnover rate has averaged 29 percent per year. After paying taxes on the resulting capital gains, investors in the 28 percent federal tax bracket have been able to keep 95 percent of their pretax gains, or 18.1 percent per year. That still beats the market. At Fidelity Blue Chip Growth, a 210 percent average annual turnover rate has uncaged sufficient capital-gains taxes to cut investors' after-tax return to 16.9 percent per year. That's just a hair better than the 16.7 percent after-tax return of the popular Vanguard Index 500 fund, which mirrors the market and which by design has very low turnover.

Don't ask. The industry would rather not make its fondness for trading a subject of discussion. Fidelity, Janus, and the Phoenix Funds--all known for lots of trading--declined to discuss turnover at all. "We don't consider turnover to be a big issue," said a spokeswoman for Janus.

If patient investing pays off, why don't more fund managers practice it? Most managers believe earnestly--if arrogantly--that they can improve results by frequent trading, says Bill Dougherty, president of Kanon Bloch Carré, a Boston-based consulting firm that analyzes funds for U.S. News. But that's only part of the answer. "Fund managers are under great pressure to perform well every quarter and every year," Dougherty says. "And much of that pressure comes from investors, because short-term performance is what sells mutual funds."

Any manager who hadn't already gotten that message was certainly alerted by what happened at Fidelity Magellan Fund last year. Several years into a successful stint running the biggest and best-performing fund in history, veteran manager Jeffrey Vinik switched about one third of the fund's portfolio from stocks, which had run up in price, into bonds and cash, which he thought were a better bet. When the move proved ill-timed--stocks rose and bonds slumped--punishment was swift. Investors have pulled billions of dollars from the fund; Vinik decided to leave Fidelity to start his own management company. "You would have thought Magellan was the worst fund of all time," says Dougherty. "It had one bad year out of 20."

Most fund managers have far less experience than Vinik does. How much slack, then, will investors cut them? With little faith that investors will stay the course through a slump--the hallmark of true, long-term investing--managers tend to figure that "they might as well try to fix anything the minute it looks broken," says Hale & Dorr's Wilson. "That's why they trade all the time. Their rationale is that investors who pull out won't get the benefit of a long-term strategy anyway."

Fund companies could take the short-term heat off managers by encouraging them to invest with a long-term focus and rewarding them when they do, investor fickleness be damned. "You can get a person to manage a fund in any number of ways if you make those ways important," says Tom Gariepy, a spokesman for the Colonial Funds group. A few firms, including Vanguard, Eaton Vance, and Colonial, have opened "tax managed" funds that minimize capital gains by keeping turnover very low. Vanguard's Tax-Managed Capital Appreciation Fund, for example, invests in large- and medium-size companies; it had a turnover rate of just 12 percent last year and gained 20.9 percent. (Don't expect to see such funds in tax-deferred retirement plans such as 401(k)'s; the tax benefits would be redundant.)

The relatively few managers with the grit--and enough support from above--to come to work and do almost no selling, even through rough periods, tend to own their own fund companies, to have excellent long-term records already, or both. Investors who decide to sign up with such funds now will have to be equally resolute. Should the market drop sharply, managers committed to low turnover are probably the least likely to sell stocks and run for cover. Shareholders will need patience--but at least they won't be the only ones who have it.

HOW PATIENCE PAYS OFF

A fund manager loyal to his portfolio

Fund investors have made great money in this seemingly endless bull market. What's your gripe?

Those gains have been a function of generally rising prices, not good management. Funds are trading incessantly, essentially selling anything that isn't moving with the market, taking the money and buying what's already moved up. That's just playing the market.

As opposed to . . .

As opposed to investing. Fund companies talk about how much shareholder money is spent on research, about how knowledgeable they are. When you have portfolio turnover of more than 100 percent, it makes little difference what you know about a company, because you'll own it for less than a year.

What is your turnover goal?

About what we did last year, 11 percent. There's been zero turnover in our largest positions--Electronic Data Systems, AT&T, Hughes Electronics, Sallie Mae. We've just kept buying more as money has come into the fund.

Obviously, each of those stocks has suffered some hard times in recent years.

We start to buy a stock when it's been dropping, when the majority opinion is negative. Usually we expect it to continue to drop, for months or even years.

Then why not wait until it drops more?

Sometimes you hit them right on the bottom, but it's very rare. Sallie Mae, the Student Loan Marketing Association, fell by nearly 60 percent, from about $76 to $31, starting in 1993 when Bill Clinton suggested putting the federal government directly into the student lending business. But it took two years to reach bottom. We started buying at $48 and bought it all the way down. Yesterday it closed at $119.

When will you sell a stock?

Only if something goes seriously wrong with the business. Value derives from the business, not from the stock. That's why successful investors won't spend their time studying stock-market dynamics. They'll educate themselves to understand businesses.

Your fund is lagging the market this year, 9 percent to 15 percent.

Cable TV stocks have dropped, and those are the businesses--U S West Media Group; Cox Communications--we've been putting much of our new cash into. When we're pouring money into stocks other people are selling, we have to underperform the market. I'm not spending one second worrying about that.