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Bleak Year Brought Almost No Winners
Average Fund Dropped 30 Percent, But Diversity Saved Some Investors

By Heather Landy
Special to The Washington Post
Sunday, January 11, 2009

Here's how brutal 2008 was for mutual fund investors: The worst performing fund was down nearly 60 percent, the average financial fund declined 42 percent, and not one diversified stock fund bigger than $100 million ended the year with a gain.

Overall, the average mutual fund plunged 30 percent in 2008, and many didn't fare as well as the Standard & Poor's 500 stock index, which fell 38 percent for its worst year since 1937.

Mutual funds' dismal performance contributed to the anguish of retirement investors who saw the slump in their 401(k)s probably prolong their working lives. Disappointment understandably runs deep among investors who together have $9.4 trillion in U.S. mutual funds.

But painful as 2008 was, mutual fund investors fared better than many others. The financial crisis exposed a broad array of risks that crushed investors in other types of vehicles. The way mutual funds are structured and administered saved many investors from the worst of the market collapse.

"You do not see mutual funds imploding like hedge funds or like private equity funds, and there are several very good reasons for that based on government oversight and regulation," said Louis Lowenstein, a professor emeritus of finance and law at Columbia University.

Lowenstein published a book in April called "The Investor's Dilemma: How Mutual Funds Are Betraying Your Trust and What to Do About It." He takes a hard line on mutual funds. But he said that since his book's release, he has moderated his views somewhat, at least when comparing mutual funds to the alternatives.

He still thinks too many fund companies overcharge for their services, but he said he admires the transparency that mutual funds provide to investors. He also appreciates their "almost perfect liquidity," so that typically when you want to pull your money out, "you can call on Tuesday and have it by Wednesday."

The same can't be said of hedge funds and private equity firms, which disclose comparatively little about their holdings and often lock up client funds for months or even years at a time.

University of Mississippi law professor Mercer Bullard, a mutual funds shareholder advocate who has taken aim at the industry in the past, said the relative safety of mutual funds was underscored by the December discovery of Bernard L. Madoff's alleged $50 billion Ponzi scheme, which punctuated an already harrowing year for many who had waded into more exotic, less-regulated funds.

"At least with mutual funds, you have a public accountant certifying the financials, and you have mandatory diversification and an independent custodian," Bullard said. "Those factors will ensure that your investments will be there, even if they may decline."

Of course, diversification -- long a major selling point for mutual funds -- proved to be of little value in 2008 as investors found few places to hide.

"I think investors are beginning to realize that putting half your money in domestic stocks and half in small and international stocks is not a diversified portfolio," said Rob Arnott, chairman of Research Affiliates, which develops and licenses investment strategies for professional investing firms.

But if broad exposure to stocks is still part of your strategy, as many financial advisors recommend, mutual fund investing can be a cost-effective way of achieving it.

For many of us, paying the average 1.5 percent fee charged by professional fund managers works out to be cheaper than paying commissions on a basket of individually purchased stocks. If you pay $10 per trade and want to own 15 stocks, that's $150 just to put your portfolio together. So you're only saving money if you invest at least $10,000, or more than that if you factor in the cost of subsequent trades.

That said, investors buying and selling stocks on their own have more control over their portfolios and more flexibility to switch out of positions quickly.

"This is a trading market," said financial adviser Frank Ruffing at Farragut Resources in McLean. "The buy-and-hold strategy worked until you had to get out of AIG or whatever [other] company, and the big funds couldn't. They just rode it right into the dirt."

There's a similar risk with exchange-traded funds, which have been gaining in popularity as a cheaper alternative to mutual funds. ETFs track indexes like an index mutual fund, but can be traded like a stock.

"ETFs are a fine choice -- they are lower cost than many comparable funds," said Jeff Tjornehoj, senior research analyst for mutual fund tracker Lipper. "But you're not getting active management, which can go both ways. The ETFs may hold firms that are just going down, down, down, and you don't have the opportunity to get out until the index is rebalanced."

As important as nimbleness can be, it's not what Tom Forester, manager of the $60 million Forester Value Fund, credits for helping him eke out a gain for 2008.

"I think for last year a bigger benefit was just knowing where to be and avoiding the blow-ups in the first place," said Forester, whose large-cap stock fund posted an 0.4 percent increase for the year.

By tracking home prices relative to income, Forester sensed the trouble brewing in the housing market and steered clear of banks, Wall Street firms and insurers that were big holders of mortgage securities. He also went light on technology stocks, loading up instead on defensive names in health care and consumer staples. Among his picks were Wal-Mart and McDonald's, the only stocks among the 30 blue-chips in the Dow Jones industrial average to rise in 2008.

But how do you find the right funds with managers you can trust to make the right bets?

It isn't easy.

"People spend several hours more per year shopping for a new car than they do shopping for the right fund or investment," Lipper's Tjornehoj said. "There's just reluctance to learn a new skill. Manager experience or manager skill is not something that's easily conveyed to an investor the way miles per gallon or styling is to a car shopper."

Research firms like Lipper and Morningstar and upstart Web sites like Fundalarm.com can help you sort through the options. But whatever you do, the experts warn, don't rely on past performance as an indicator of the future.

"People are definitely attracted to high performance," said Jonathan Jay Koehler, an Arizona State University business and law professor who has run studies to gauge how investing novices and professionals react to the presentation of mutual fund performance data. "But hot funds often get a gigantic inflow of money, and then underperform thereafter."

In other words, when you invest can be crucial to the overall performance of your fund, which makes it all the more difficult to assess the value of a professional manager.

The time horizon used to measure or compare funds also might skew your sentiment. Funds specializing in Latin American stocks, among the worst performers in 2008 with an average 55 percent decline, show a far more palatable 2.9 percent decline over a three-year period, and a relatively enviable 14 percent return over five years, according to Morningstar data.

David Ellison, president of FBR Funds and a 25-year veteran of the investing business, said it's more important for fund managers to preserve client money in bear markets than it is for them to chase returns in bull markets.

"The better managers show up in difficult times," said Ellison, whose FBR Small Cap Financials Index was down 8.7 percent in 2008, compared with an average drop of about 45 percent among peer funds. "If you can outperform, it really helps people in the long term because when things move back up, they have more money to put to work in the market. We're at a point now where for some people, the market needs to go up 100 percent for them to get their money back."

Ellison acknowledges the critics who say fund companies, which typically take a percentage of the assets under their care, are more interested in getting money from clients than they are in making money for them.

"Yes, I earn money [on fees] because there's assets in the fund." But Ellison said he'd prefer to have fewer clients if they were committed to the longer term than more assets from speculative investors.

"If I have to make less money, so be it," he said. "People are over-invested in the market relative to what they're really comfortable with, and that's why we have some of the volatility we're having."

Ellison said that too many people have forsaken investing for speculating, in the hopes that a well-timed trade will yield a big payday.

"People want to get in, they want to get out, then they're thinking the market is going to get back up and they don't want to miss it," he said. "Look, the market is not going to get you rich, it's not going to make you friends, it's not going to care about you. And this year was a good example of how the market doesn't care about anybody."

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