The Siren Call of Mutual Funds

By John Greenwald

For the millions of Americans who have poured a record torrent of their hard- earned cash into mutual funds, this should be the best of times. Last Thursday the Dow Jones industrial average went over 3700 for the first time ever, bearing with it the yields on many stock and bond funds. The average aggressive-growth fund has risen 29% in the past 12 months. Corporate-bond funds gained 13% overall. Commercial banks, fully aware how anemic their certificate-of-depo sit rates look in comparison, are actively luring customers into the wealth-generating world of funds. As a result, mutual funds sold through banks now account for about 15% of all new fund sales.

When the bulls are running, that's all well and good. But what happens if the market heads south, in the kind of correction some analysts think might happen soon? Much of the money that has flooded into mutual funds could flood back out, transforming an otherwise modest correction into a rout. "The money that's in there is nervous money," frets Rubin Bergay, a retired Anaheim, California, engineer who is heavily invested in funds. "There's no doubt the interest in funds is governed by the low CD rates, and I'm very concerned that investors will take the first opportunity to get out when interest rates rise or the market turns down."

Compounding the risk is the fact that many refugees from 3% CDs may have - bought their funds on the false assumption that these higher-yielding investments are also covered by federal deposit insurance. "Small bank savers may think that since banks are selling them, they're as safe as CDs," says John Haslem, a University of Maryland finance professor. They're not.

The frantic rush into funds has naturally caught the eye of politicians and regulators in Washington. Henry Gonzalez, the Texan who chairs the House Banking Committee, last month submitted a bill that would require banks to sell funds in areas separate from teller windows; Gonzalez also wants banks to require customers to sign a statement that they understand that mutual funds are not insured, thereby lending the force of law to federal guidelines already on the books. Representative Edward Markey, who chairs the finance panel of the House Energy and Commerce Committee, is preparing a bill to tighten standards on mutual-fund management and advertising. "Mutual funds are a lot like the Philadelphia Phillies," Markey says. "Great organization, great starting pitching, superb hitting, but they need to address a few shortcomings in order to be perfect."

The growth of the U.S. fund industry has been startling by any measure. Just 16 years ago, there were 477 funds. Investors today can choose from over 5,000, more than all the companies listed on the New York and American stock exchanges. A new fund opens for business every day. People can buy shares of an environmentally correct fund, or one managed by astrologers, or a venture capital fund that invests in companies owned by women. A California money- market fund offers frequent-flyer miles at the rate of one mile for every $10 invested for one year. Americans have poured more than $80 billion into mutual funds so far this year, already surpassing the record $78 billion for all of 1992. That has raised the total assets of U.S. funds to $1.9 trillion, an amount equal to the gross domestic products of France and England combined.

The sheer convenience of mutual funds makes them attractive to almost anyone. "If you have $100,000 to invest, it's not easy to track it closely every day," says Barb Wiener, a homemaker in Irvine, California, who uses a computer to manage her family's finances. "You choose a couple of mutual funds, and you only have to look two or three places to keep track of how well you're doing." All told, 1 in 4 Americans owns mutual funds directly or through group plans; half the families have incomes of less than $50,000, making funds the primary financial asset of the middle class.

Underlying this success is the buoyancy of individual stocks. Every major U.S. stock index has been hitting new highs. At the same time, foreign exchanges from Singapore to Stockholm have been setting records of their own (see box). All that makes the pros nervous. "By the 5th of November, if we don't have a 10% drop, we will have had the longest-running stock-market expansion in modern times," says A. Michael Lipper, president of Lipper Analytical Services, which tracks mutual funds. "We're clearly long in the tooth." Says Dan Case, president of the San Francisco-based brokerage Hambrecht & Quist: "If you look at the investment options, it's clear that mutual funds have been the right decision, but I think we're getting close to the point where that's no longer true. It is all but certain that the returns even outstanding professional money managers get will go down."

Many risk-averse investors continue to cling to CDs, which still hold $1.2 trillion in cash. "I wouldn't say people are nuts to have money in CDs," notes a staff member with the House Energy and Commerce Committee. "The government guarantee is worth something. A family of extremely modest means should have three months of savings to meet immediate cash needs in an emergency. There's nothing wrong with keeping them liquid and guaranteed."

For their part, commercial banks have clearly found it profitable to participate in the fund boom. Roughly 125 large banks now offer their own branded funds, which are managed by outside investment firms. That trend has turned a little-known Pittsburgh firm called Federated Investors into the seventh largest fund group in the country. Federated has sold 80% of its $75 billion in assets through institutions under either its own name or the institution's brand. Either way, the banks typically take the lion's share of the sales fees.

The rapid growth of fund sales through banks is just one reason why Congress is taking a closer look at the industry. Another is a recent series of cases involving abusive practices. Just last month, Chicago-based Kemper Financial Services agreed to pay more than $10 million to settle Securities Exchange Commission charges that a former portfolio manager had credited lucrative trades to his employee profit-sharing plan while dumping lesser transactions on two mutual funds. Also last month, First Investors Corp. settled charges brought by five states that had accused the firm of misleading customers, many of them retirees, who bought First Investors' risky junk-bond funds. The company agreed to pony up a total of $33 million in restitution, the most ever paid by a mutual-fund firm.

To improve oversight, Markey wants to double, at least, the 110 SEC regulators who police funds. "The regulators are spinning their wheels, not coming close to keeping pace with a decade of spectacular growth," says a senior House staff member. "We're not worried about Fidelity, Vanguard or Merrill Lynch. But we need greater resources to look at the newer funds."

Markey also wants the SEC to exert stricter control over fund advertising, particularly when funds boast about their performance ranking. Investors face a barrage of claims that one fund or another ranks No. 1 in its field, no matter how narrowly that field is defined. To clear up such matters, Markey wants the SEC to require any fund claiming to be No. 1 to state how many funds it was comparing itself with and over what period of time.

The Congressman particularly attacks the $3 billion Pilgrim Group, which is based in Los Angeles, for implying in two January ads that five of its funds were ranked No. 1 through No. 5 in 1992 performance. "The Pilgrim ads appear to be the most egregious examples of manipulating mutual-fund rankings of which I am aware," Markey says. Concurs Don Phillips, the publisher of the fund research group Morningstar: "An argument can be made that Pilgrim is the worst among all fund groups with at least $1 billion in assets." Retorts Palomba Weingarten, the Pilgrim Group's chairman: "I'm glad Congress has nothing better to do but worry about my ads. They were not misleading. They were statements of fact. More than 90% of our assets are performing well."

With the bull market now entering its fourth and perhaps final year, is it time for the little guy to get out? Not Gerald McCoy. A retired Arizona engineer, McCoy put his life savings of nearly $400,000 into stock and bond funds when he took early retirement in 1991. "I'm very squirrelly right now," he concedes. "This bond market has lasted long enough to make you feel queasy. If a correction happens tomorrow, though, I'll leave my money where it is."

And that is just what many advisers would counsel him to do. They note that shareholders invariably do better by staying in for the long haul than they ! would by selling their funds at a loss. Most investors have been behaving as if that was true. "People redeem much less than they used to in a bear market," says Avi Nachmany, an analyst with the research firm Strategic Insight, which recently examined seven bear markets over a period of 30 years. "When people don't know what to do, they tend to do less." Case in point: holders of stock funds cashed in just 2% of their assets in the 1987 crash, according to the Investment Company Institute, the fund industry's trade group.

While no system or advice can ever be foolproof, here are some tips for mutual-fund investors from the perspective of common sense and seasoned market watchers:

-- Review the annual fund rankings in major business magazines and choose funds that have done well in both good markets and bad going back perhaps 10 years. Remember that today's hottest funds may have already peaked.

-- Diversify into a few funds and stay in the market for at least 10 years if possible, no matter how it performs. That should enable you to recoup any losses.

-- Choose no-load funds over loaded ones that carry a sales fee when bought or sold. The no-loads perform just as well on average.

-- Beware of brokers who earn heftier commissions for pushing some funds over others. Don't be afraid to ask brokers how much they make on each fund.

-- Throw away the fund prospectus unless you are a lawyer or accountant. Markey's upcoming bill will require these turgid and confusing documents to be written in plain English.

Such advice cannot, of course, protect investors against the next downturn. But it could help market newcomers and veterans alike ride out the tide if even some of the money that has been surging into mutual funds should slosh back out.

CHART: NOT AVAILABLE

CREDIT: TIME Graphic by Steve Hart

CAPTION: THE BEST

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With reporting by Richard Behar/New York and Dan Cray/Los Angeles