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Course 502
Fund Warning Signs

Introduction

All good things must come to an end. We all know about the shelf-life of television shows, for example. Remember when "Who Wants to be a Millionaire?" was the most exciting thing happening to American audiences?

Mutual funds can also lose their magic. We'd love to say that a good fund will always be good, but funds change. Performance slips. Managers leave. Strategies evolve. That's why funds need to be monitored.

Here are some of the warning signs to watch out for. These aren't sell signals per se: Instead, think of these as signals that change may be on the way-the mutual fund equivalent of dwindling audiences, sour writing, and producer desperation.

Asset Growth

This may seem counterintuitive, but sometimes mutual funds actually need smaller audiences. As funds attract new investors and grow larger, their returns often become sluggish, weighed down by too many assets. They lose their potency and their returns revert to the average for their group. Some funds stop accepting money from new investors when their assets grow too large, but many don't. That explains why so many once-hot funds become mediocre.

There are worse things than being average, of course. But you may still want to keep an eye on your funds as they grow, especially your small-growth funds. Sometimes mutual fund shops will do the monitoring for you. Longleaf Partners Small-Cap Fund, for example, closed in 1997, after asset inflows left the fund with a sizable cash stake that the managers had trouble putting to work. Since its closing, the managers have continued to ply their deep-value style, trawling for small-cap names that are overlooked and misunderstood, and have generated superb, though streaky, results.

Even shops known for their discipline and their great performance can get caught in this trap. American Century Ultra (TWCCX) racked up excellent returns in the 1990s picking small firms with lots of growth potential. The management team was vigilant about selling companies as soon as their share prices increased. Investors flocked to the fund, but returns eventually slowed because the managers just couldn't execute their fast-trading, super-growth strategy with so many assets in tow. So what did they do? They changed their strategy. They now buy larger companies and trade less often, and performance has also moderated.

American Century's strategy change is a perfect example of how asset growth can affect a fund: Fund managers often have to alter their strategies to accommodate new money. Some simply buy more stocks, buy larger companies, or trade less. (When big funds trade frequently, they risk affecting their stocks' share prices as they buy and sell.) No matter what they do, though, they have to make concessions or close the fund. And as a shareholder, you need to be aware of the change and consider whether or not this altered fund fits into your portfolio. American Century Ultra shareholders no longer own a small-growth fund, they own a large-growth fund.

Some types of funds are more hurt by asset growth than others. We'll talk more about this topic in our next lesson.

Manager Changes

Most mutual funds are only as good as the people behind them: the fund managers. Managers decide what to buy, what to sell, and when to make these changes. Because the fund manager is the person who is most responsible for a fund's performance, many investors wonder if they should sell a fund when their manager leaves.

Unfortunately, there is no one right answer to this question. You'll need to consider a few factors. For example, you may have to pay taxes on your sold shares, if they've appreciated since you bought them. And what you give up in taxes may not be offset by future gains in a different fund. You'll also need to consider the record of the new manager-perhaps he or she has already worked on the fund? Perhaps the manager has racked up a solid record at another offering? Keep in mind: A new manager may do just as well as the old.

Further, management turnover won't make much difference when it comes to certain kinds of investing styles. Consider index funds. Managers of index funds are not actively choosing stocks, they're simply mimicking a benchmark. Thus, manager changes at index funds are less important than manager changes at actively managed funds.

Sometimes, it's clear that management turnover is a non-issue. Some fund shops have deep benches, strong analyst training programs, and extensive research support. These firms have historically had plenty of talented managers and analysts who can take over when a manager departs. Similarly, funds run by teams are often less affected by manager changes. If one team member leaves, there are often two or three other managers who will remain behind.

Of course, changes in management can be a crushing blow to funds run by a single fund manager who has proved to be an adept stock-picker or trader in markets in which there are a wide range of possible returns (such as small growth or emerging markets). Manager changes at good funds from families that aren't strong overall are bad news, too.

Fund-Family Growth, Mergers, or Acquisitions

Why should it matter to your fund's performance if the sponsoring fund family decides that it wants to add some new funds to its lineup? Or that it wants to be sold or become independent? It may not seem like much, but those things can distract managers from doing their jobs. After all, if your employer is growing rapidly or is on an acquisition binge, doesn't that affect how you do your core job?

Once-great funds may also stall or lose their focus when their families expand and launch new offerings. Furthermore, funds can be forced to fill a different role as its family grows. Take Oakmark Fund (OAKMX). This one-time small-value fund is now firmly entrenched in mid- to large-cap territory. Initially, that upward shift was an intentional move by the fund's manager. However, as Oakmark expanded, it launched two dedicated small-cap funds, Oakmark Small Cap I (OAKSX) and Oakmark Small Cap II (OARSX). Now, even if current Oakmark manager Bill Nygren wanted to focus on small caps, it's unlikely that the fund would become all small again. The family already has funds that fill that role and the shop can't afford redundancy.

Keeping Watch

How can you find out if your funds are on the verge of change?

First, keep tabs on your fund families using the public information available. Regularly visit their Web sites and look for news of growth plans, mergers, and new fund launches. Get access to information on funds in the pipeline in the EDGAR section of the SEC's Web site (sec.gov), where fund families must register their funds. Finally, always scan the marketing materials that jam your mailbox.

Next, turn your attention to third-party sources, including Morningstar, and learn what these groups have to say about your funds and your fund families. Firms such as Morningstar aren't in the business of selling their own funds and they take their roles as industry watchdogs seriously. Check out our fund news, read our fund analyses, and see what other investors in your funds are saying on our conversation boards. Make sure to read what members of the financial media are saying, too.

Finally, check up on your funds each month to make sure that things are status quo. Have their assets grown rapidly? Are their managers still in place? Is there anything notable going on with the fund family?

If you find that changes may be afoot, ask questions. If you find that your fund family is launching a new fund that sounds a lot like the fund you already own, for example, ask how the funds will differ and if this will mean more work for your fund manager. Or if you're worried about asset size, find out if the family plans to close the fund any time soon.

Quiz 502
There is only one correct answer to each question.

1 A fund's asset growth can lead to many problems. Which of the following is not typically one of them?
a. Sluggish returns.
b. Higher expenses.
c. A change in investment strategy.
2 As funds grow, how do managers often change their strategies?
a. They buy more stocks.
b. They buy smaller stocks.
c. They trade more.
3 A manager change is:
a. Always a sell signal.
b. A warning sign that change may be on the way.
c. No big deal for most funds.
4 Why is it important to monitor your fund families?
a. Because they're the ones choosing securities for you.
b. Because fund family growth can mean change for the fund you own.
c. Both.
5 Which is not a good way to find out if your fund is on the verge of change?
a. Keep an eye on your fund's performance only.
b. Regularly visit your fund company's Web site.
c. Read what Morningstar and other third-party sources have to say about your fund and fund family.
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