The Mutual Fund Scandals and Our Portfolios

The mutual fund scandals continue to grow. What initially was malfeasance at one hedge fund and a few managers at four fund families now appear to be widespread industry practices. The SEC said a survey of major fund management companies revealed that about 25% of the fund companies admitted to regularly engaging in such behavior, and about half said they allowed improper trades for at least one client.

Let’s get one thing straight. Despite what media reports say, the evil here is not “market timing.” Market timing might or might not be a wise investment policy, but it is not unethical or illegal. The scandals involve fund firms allowing a few investors the exclusive right to make trades that were prohibited to other investors, that violated their prospectuses, and that cost the other investors money. The trades often were guaranteed to make a profit. When I make a mutual fund trade for myself or a client, the trade often has to be in by 2:00 p.m. or it is executed the next day. The favored investors could make their trades after the markets closed.

I’m pleased, but not surprised, to see that none of the fund families in my recommended portfolios is a major player in the scandals. I don’t expect any to be implicated. The scandal does not make the case for avoiding mutual funds. Instead, it highlights the importance of selecting a shareholder-friendly fund, the kind you will find in our portfolios.

Low fees and no loads are essential for a shareholder friendly mutual fund. Most of the fund families implicated so far run high-commission, high-expense funds. When I look at the funds and fund families implicated, I see little reason to buy the funds in the first place. You don’t get anything extra by paying a sales load or high expenses. All those costs do is reduce your returns. Invest exclusively with the low expense, no load funds of the sort you will find in my portfolios.

Long-term orientation is another characteristic of a shareholder-friendly fund.

So far, two no load fund families have been in the headlines: Strong and Janus. Funds from these families rarely entered my recommended portfolios, because they tend not to be shareholder friendly. These groups built themselves by investing in highly-valued growth stocks in hopes that high returns would continue. They simply tried to post high short-term returns that they could trumpet in advertising.

The approach worked for the fund families, but not for their investors. The fund companies made a lot of money. But most of their funds declined much more than the market indexes in the bear market. Investors who did not time their purchases and sales well lost a lot of money. Don’t buy a fund that trumpets its short-term returns.

A shareholder-friendly fund invests with you. The managers have their money in the fund. This information is difficult to find. But a number of fund families brag that the managers have their money in the funds. Longleaf Partners, Dodge & Cox, Torray, Third Avenue, and Tweedy, Browne are among the funds I recommend currently or have in the past that make clear they are investing with you.

There are other factors to consider, which I discussed in my September 10 E-Mail Report. (Subscribe free at www.RetirementWatch.com.) The SEC doesn’t require enough of the right information to be disclosed to investors. Many of the “reforms” being discussed won’t help investors and actually will hurt many mutual fund investors. Follow my principles and you will be unlikely to lose your investment dollars to anything other than an honest investment mistake by the fund manager.

Now, let’s take a look at how I recommend you invest for the next month.

Sector and Balanced Portfolios

Most investors still argue over whether we are in a new bull market or in a bear market rally. There are strong arguments on each side. Yet, we won’t know which side is right (or if another scenario will unfold) for at least another year.

I suspect that we are in a strong rally that will continue, with fits and starts, well into 2004. But don’t bet on one extreme scenario. Instead, keep your portfolio positioned so that it should do well in most market conditions, as we have done since March.

This is a good time for quality stock picking. We have one of the best teams in TCW Galileo Select Equity. This growth stock powerhouse has surged ahead of the major market averages. Keep it in the portfolio, but because of its volatility keep track of the sell signal on page 10. Other funds with quality stock pickers are in the Core Portfolios.

Another good strategy at this time is to hedge against different market conditions. We have two funds in the recommended Managed Portfolios that do this.

Hussman Strategic Growth buys a diversified portfolio of growth stocks that sell at reasonable prices. As market conditions warrant, the portfolio is hedged with stock options that appreciate if the market declines. The fund can hedge from 0% to 100% of the portfolio. Hedging in this way allowed the fund to post strong gains in the bear market. Dropping the hedges let it earn solid returns in the rally. Recently the fund has hedged about 50% of the portfolio because manager John Hussman believes the market has strong positive trends but is overvalued.

Our other fund that hedges is AXA Rosenberg Global Long/Short Equity. (Charles Schwab recently announced plans to buy this group of funds. I’ll be tracking whether this move affects availability of the funds to non-Schwab investors.) The fund sells short stocks it believes are overvalued and buys stocks it believes are attractive. The short sales hurt it through August, because the most overvalued stocks achieved the highest returns. More recently, things have turned around and the fund established an uptrend. The fund returned over 50% in the bear market.

Diversification is another good strategy for this market. Real estate investment trusts, especially through Cohen & Steers Realty Shares, are an excellent diversification. Historically REITs do not rise and fall with the major market averages, though they have in the rally since March. The fund pays a dividend of 4% to 5%, which protects the value in a market decline. The growing economy should improve vacancy rates and rents. I’ve had a sell signal in place for the fund because of uncertainty about the economy, and I’ll keep it in place for now.

Income Growth and Income

Income-oriented portfolios should remain in defensive positions. Interest rates hit bottom last summer. Yields retreated from their panic tops in August, but that decline should be temporary. As the economy grows over the next year or two, interest rates should rise a bit. That will hurt most bonds. Yet, we should be able to achieve our goal of a 4% to 5% yield with some capital gains in the recommended Managed Portfolio.

The foundation for a portfolio that earns a good yield with a lot of protection is Vanguard Short-Term Corporate Bond fund. Because the bonds are short-term and issued by corporations, their values won’t decline as much as values of other bonds when rates rise.

We’re also getting both yield and protection in Vanguard Inflation-Protected Securities fund, which owns Treasury Inflation Protected Securities (TIPS). The principal automatically adjusts for increases in inflation.
Cohen & Steers Realty Shares also is in this portfolio for its yield and capital gains potential.

In the Income Growth fund I also include a balanced fund that buys value stocks and conservative bonds, primarily corporate bonds. My top choice is Dodge & Cox Balanced.

Alternative recommended funds for all these portfolios are on page 11 of each issue. I list alternative funds in the major fund families for most of my top choice recommended funds. Also listed are funds I recommend in the no transaction fee (NTF) programs at most of the mutual fund brokers. You can find some additional selections on the web site as my Carlson’s Choice Funds. In addition to the regular contact information, the web site provides returns for different time periods over the last year.