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  • By Tim Smart
    Washington Post Staff Writer
    Sunday, January 10, 1999; Page H03

    Here come the style police.

    No, it's not someone checking on whether your paisley cravat matches your starched cotton broadcloth or your argyle socks clash with your blue serge suit.

    Rather, these are the people who work at several mutual fund companies entrusted with the job of ensuring that your mid-cap value mutual fund is, in fact, loaded up with $5 billion of blue chips down on their luck and not the latest Internet wonderstocks.

    Policing "style drift," the term the mutual fund industry uses to describe the intentional as well as inadvertent wandering off course of portfolio managers, is a hot topic these days. That's especially true given the soaring stock market and the preponderance of mutual funds that have stoked their performances with concentrations of a few well-known big-cap stocks despite investment philosophies that might suggest different courses of action.

    "You can't suddenly put IBM into a small-cap growth portfolio," said Thomas Reilly, chief investment officer of value equity funds at the Putnam group in Boston.

    Reilly and others in the industry point to the performance of the giant Fidelity Magellan fund to illustrate their point. Under famed portfolio manager Peter Lynch, Fidelity was a star performer that specialized in small and medium-value growth stocks. But Lynch's successor, Jeffrey Vinik, made a series of bets on investments far afield from what Magellan investors assumed was the fund's charter (although Magellan has a very loose definition of its purpose).

    In 1995, Vinik loaded up on technology stocks, then abruptly reversed course and put more than a third of the $50 billion fund into government bonds. The bets backfired. Shortly thereafter Vinik was gone. A new manager has since restored Magellan's luster, though with a portfolio heavily tilted in favor of stocks of big-name companies such as General Electric Co. and Microsoft Corp.

    And Fidelity itself has paid more attention to the issue of style, reining in some of its more aggressive funds and launching an ad campaign featuring Lynch that preaches the gospel of knowledgeable investing.

    It may not matter to most investors what their fund is investing in -- as long as it makes money. And Magellan handsomely beat the Standard & Poor's 500-stock index last year with a 33.6 percent return.

    But financial advisers stress diversification, especially for long-term investors saving for retirement, and it is difficult to spread an individual's risk, say, among value and growth funds as well as by size of company, if funds are not keeping to their stated missions.

    "We start with the basic proposition that we can't forecast anything," said Jeff Molitor, chief cop at the Vanguard family of funds.

    Molitor and others such as James Kennedy at T. Rowe Price Associates Inc. are ardent believers in the need for fund managers to stay in their "boxes" when making investments. They believe that it is an act of betrayal for companies to offer investors a fund that purports to be one thing while behaving like another.

    "Intellectual honesty starts at day one here," said Kennedy, who oversees a committee at T. Rowe Price that regularly reviews all of the buying and selling of each of the company's more than 75 funds. If a manager is straying too far from the stated philosophy of a fund, Kennedy and other senior managers who make up the firm's style committee will consult with the manager to determine whether the drift is intentional or has happened unnoticed.

    Kennedy said the trend has been for managers to become more conservative as time goes on with their funds, not more adventurous. "They'll generally get more of a conservative streak than they should for their charter," he said.

    If the manager resists the friendly conversation with superiors, Kennedy added, "The friendly uncle's arm around the shoulder gets a little tighter."

    It's a rare case, Molitor and Kennedy said, when the disagreement over direction becomes so large that it results in the manager's departure, but it does happen.

    At Vanguard, which used outside firms to manage its stock portfolios, "We have made those changes and we will continue to make them," Molitor said. At T. Rowe Price, the former manager of a specialty health-care fund left the firm over disagreements about his investing style, which company officials will only say was tilted more toward biotechnology and small medical equipment companies than the firm thought prudent.

    "I have my mother in certain funds for certain reasons," Kennedy said. "If that portfolio manager breaks his promise with me, I'm probably not going to own that fund."

    The issue of style drift, and the inability of investors to adequately diversify, is being complicated by the trend of the past couple of years of the S&P 500 to be heavily dominated by a few large, high-performing companies. These include GE, Microsoft and Cisco Systems Inc.

    What this has done, fund experts said, is tilt the index toward higher-volatility technology and health-care stocks, which make the S&P riskier and less representative of the broader market than it once was.

    In the 1960s, Vanguard Senior Chairman John Bogle said, the S&P 500 was heavily influenced by the performance of 10 stocks, including General Motors Corp., DuPont Co., and Sears, Roebuck and Co. Today, the leading performers, aside from GE, are technology stocks, which traditionally have more volatile swings in their stock prices.

    "This is not your father's or grandfather's S&P index," Bogle said.

    The reason this matters is that most fund groups advertise their performance in terms of how well their funds did in comparison to the S&P. The portfolio managers also are paid according to how well they have done in relation to the index.

    But, for someone seeking to diversify away from a dependence on volatile growth stocks, for instance with a value or blended stock and bond fund, it becomes harder to do so when the funds are straying.

    Consider four Fidelity funds that have different stated purposes (though their charters are sufficiently broad to allow portfolio managers huge discretion): Fidelity Growth & Income, which seeks to balance capital appreciation with high dividend-paying stocks; the Fidelity Fund, which is a long-term growth fund with a current income blend; Equity-Income, the name of which describes its focus; and Dividend Growth, which is focused on companies with high or increasing dividends.

    As of December, all four funds counted GE as either their largest or second-largest holding with Microsoft usually close behind.

    Of course, there's nothing wrong with either stock. Both have posted stellar returns in the past few years, making shareholders rich in the process.

    But an investor would hardly be diversifying his risk portfolio if he owned Magellan -- in which GE is the biggest holding also -- if he bought Equity-Income, for example. A Fidelity spokesman said an investor seeking true diversification should seek out bond and other non-stock funds.

    Eric Kobren, a former Fidelity marketing manager who now publishes newsletters that track funds offered by Fidelity and other companies, monitors the similarity of Fidelity funds to each other and to the S&P index.

    According to Kobren, Equity-Income's portfolio is 95 percent the same as Magellan's, which itself is 97 percent similar to the S&P.

    Another fund that appears to have a portfolio different from what one might expect given its moniker is Legg Mason Value Trust. Its investment strategy, as detailed in its own marketing literature, says the fund "seeks growth of capital using the 'Value Approach' to investing."

    Yet among the top 10 holdings in Value Trust are Dell Computer (No. 1) and America Online Inc. (No. 2). Both stocks have been standout performers of late, yet most experts would hardly describe them as value stocks in the traditional sense of selling at price-earnings ratios below the market. AOL, for example, has a P/E ratio -- its price as a multiple of its annual earnings per share -- of 626, compared with the S&P P/E ratio of almost 35.

    Still, by one definition, AOL has been a classic value stock, in that its value was not appreciated by investors until recently. The stock is up 575 percent over the past 12 months.

    An exaggerated example, certainly. But in some ways, AOL serves as the perfect reminder that style does matter, but not as much as staying informed about your investments.

    "The basic premise is you have to know what you're buying and why," he said.

    © Copyright 1999 The Washington Post Company

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