Stuck in all seasons?

Why do many fund managers hold on to losing stocks in down markets? Because exposure to certain sectors is more important than performance.

In 2000, Jack Lindsey's family contacted Fidelity Investments and asked for direction in making an investment. The Fidelity representative asked a few questions about the family's investment time frame and interests and then suggested the Select Technology fund as a possible investment. Shares were purchased.

A number of months went by and Mr. Lindsey began checking on the investment results. The Boston resident was not alone in watching a remarkable decline in the value of the shares. Thousands, if not millions, watched as the shares plummeted 37 percent in the fourth quarter of 2000. And the trend continued as the share price dropped 32 percent in 2001 and another 38 percent in 2002.

Lindsey was not a novice investor and understood that stocks involve risk. He believed, however, that a fund actively managed by an investment professional (in contrast to an index fund which is not actively managed) would take some significant action to avoid massive losses rather than remain almost fully invested and merely mirror the declines of the technology sector. "We thought the mutual fund would act in our best interests," says Lindsey.

But that's not how many mutual-fund companies see it, which puts sector-fund managers in a bind. Should they raise cash or seek greener investment pastures when it's best for their shareholders? Or stick with their investment sector, even when it's headed for a fall?

The answer: Managers usually stick to their sectors. So despite all the mutual-fund rhetoric about serving the shareholder, investors need to take an especially close look at their tolerance for risk before jumping into a sector fund.

"When you buy a stock fund, it's the plan of most mutual-fund managers to invest in their best ideas within the equity market and not to market time, not to raise huge amounts of cash," says Eric Kobren of the Kobren Insight Group. "The fund manager is generally not going to get investors out of the way of a declining market."

Investors may be excused for believing differently, given what they hear from mutual-fund companies.

"The idea is to make the most money for the shareholders and to work in the best interest of the shareholders," says Sarah Friedell, a spokeswoman for Fidelity. But "somebody buys a mutual fund to be invested in something. If they wanted to be in cash, they would be in a money market or another vehicle. Select Funds or sector funds are for individuals who already have a balanced portfolio and who want exposure to a specific piece of the market for a specific reason. The idea is to be fully invested, because if the market has an upturn, they want to take advantage of that."

Edward Johnson III, chairman of Fidelity, "had always believed that people who handed over their money to Fidelity did so in the expectation that it would be invested in the market," writes Joseph Nocera in his 1994 book, "A Piece of the Action."

There's no need to single out Fidelity. Vanguard and many other mutual-fund families echo the sentiment, at least with respect to funds with industry or sector specialization.

Mr. Nocera, for one, criticizes that stance. "Surely, though, Johnson was giving his customers too much credit," he writes. "Most middle-class investors found mutual funds appealing precisely because they wanted someone more knowledgeable than they to make market decisions on their behalf. The decision about whether or not to be fully invested was exactly the kind of judgment a novice investor would want his fund manager to make."

Outside advice

What about investors who use an adviser? Many individual investors rely on a financial planner or investment adviser to help them make decisions about how fully to be invested. In fact, "87 percent of all money going into mutual funds is going in through intermediaries," according to the Investment Company Institute.

Those who provide advice may prefer such sector loyalty. Often, they want mutual funds that provide clear-cut exposure to market styles or sectors. And they don't want the fund to surprise them by raising cash or by hedging the portfolio against a decline. "Sector funds are designed to reflect a sector, not to protect investors against market declines," says Sheldon Jacobs of the No-Load Fund Investor.

Unfortunately, many individual investors don't see it that way. They often turn to sector funds to avoid the risk of owning a single stock. And indeed, funds greatly reduce that risk by diversifying ownership across many stocks. That very action of diversification, however, makes the investor a perfect candidate for another kind of risk - the risk of a declining market.

Investors in sector funds face yet another danger. Even if the overall market goes up, they run the risk of a sharp decline in the stocks of the sector in which they are invested.

Here, too, according to Mr. Kobren and other experts, the fund manager is focused on owning his or her best stock ideas within the sector and is unlikely to significantly reduce or even address the risk of a decline in the sector.

Judging managers

Significantly, most mutual-fund managers are judged on their performance relative to that of similar funds or indices. So, if the market or sector goes down 30 percent and a fund goes down 25 percent, you, the investor, lose a quarter of the value of your holdings. But the fund manager probably gets a bonus for beating the relevant benchmark.

No one can blame Lindsey, the investor who lost money in a Fidelity sector fund. His expectation that a professional fund manager - a manager whose written objective is capital appreciation - would get out of the way of an imminent market decline sounds rational.

Fund companies often trumpet the idea of serving investors' best interests. And many fund policies give managers the leeway to cushion shareholders from downturns by raising cash or by other hedging techniques.

Nonetheless, the reality is quite different. For sector funds, at least, it appears that the determination to remain essentially fully invested outweighs anything else. Thus, other stated objectives - capital appreciation and the mutual-fund firms' pronouncements about making the most money for investors - take a back seat.

So investors, beware. Sector funds can be a great way to get exposure to a certain portion of the market. When they go up, the rewards can be dazzling. But their declines can be just as dizzying.

And don't expect fund managers to do much to dampen your fall. Whether by choice, by default, or by company policy, sector funds seem likely to remain handcuffed to the market roller coaster. And investors should understand the ride before they buy the ticket.

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