Investors need to know of mutual funds' risks


The mutual fund industry, which has rapidly ballooned to more than 5,000 different funds, is coming of age.

It now has big-time problems, just like any other major investment vehicle. While they can be solved, investors should be aware of them.

Critical mutual fund concerns in 1994 include:

* Increased use of derivatives, the aggressive game of buying and selling in futures markets for stocks, currencies and interest rates. The risky portfolio techniques that have hammered short-term global income and option-income funds are much like those that led to Procter & Gamble's disastrous loss of $102 million from ill-timed interest-rate swaps. Funds such as Piper Jaffray Institutional Government Income Fund and Managers Intermediate Mortgage Fund suffered 20 percent declines when rates rose.

Stock funds, fixed-income funds, balanced funds and asset-allocation funds put billions of dollars into derivatives. Even a small portion of derivatives can have a dramatic effect on a portfolio. But, since they must file reports on such trading only twice a year, many managers "clean up" their portfolios prior to those important reporting dates. Millions of average investors, some taking their very first steps outside bank certificates and money-market funds, are assuming new risks they didn't even know existed.

* Questionable personal trading by portfolio managers, a problem brought into focus earlier this year when star manager John Kaweske was fired by Invesco Funds Group for failing to report a number of personal trades and also his position on the board of a biotechnology firm. Whether a manager is trading strictly for investors or for himself as well can make a difference. Trading stocks for a manager's own account has resulted in "gray areas" of conflict of interest.

Involvement in initial public offerings (called IPOs), purchasing of private-placement stock before a company goes public, serving on company boards and making trades without disclosure to either the fund company or to investors can add up to trouble.

* Obscure, complicated pricing of mutual funds that goes beyond the traditional "A" front-end load (initial sales charge) funds and "B" deferred load (paid when leaving the fund). Now there are additional classes, such as the "C" funds that require a never-ending 1 percent in extra fees annually. PaineWebber Inc. is among those big in this practice. This makes it harder for investors to fathom how much they're really paying.

* Investors taking on far too many risks in order to obtain higher yields, rather than realizing that betting on 20 percent annual gains may be a thing of the past. It's important to know the risks of junk or international bonds. The Fidelity Asset Manager declined 6 percent due to its holdings of bonds and stocks from Third World countries. There's nothing wrong with such holdings, but shareholders may not have grasped what risks they were assuming.

It's time to tackle all these weighty problems, starting with derivatives. "Quarterly reporting of derivatives in portfolios would be much better than twice a year, and some fund companies already voluntarily do it," noted Don Phillips, publisher of Morningstar Mutual Funds.

The Securities and Exchange Commission is working on getting funds to come up with better explanations of their derivatives in materials given to investors. In the meantime, obtain all the materials you can and ask about the portfolio mix.

In regard to personal trading by managers, there are other issues.

"If you own stock in General Motors, you know how much of top GM executives' money is invested in the stock, but you have no information about how much money a portfolio manager personally has in the stocks in his fund," Phillips said.

A panel of the Investment Company Institute, which represents the fund industry, has recommended a number of rules, including banning managers from buying shares during IPOs, restricting the buying of private-placement stock, keeping managers off corporate boards, stopping short-term trading and requiring advance clearing of trades with the fund company. Industry firms are generally embracing those initial recommendations. Meanwhile, the SEC is completing a study of actual personal-trading practices, from which it will make its own recommendations.

The industry is smart to take steps before rules are forced upon it.

"This is a perilous time for investors because there are major risks they aren't even aware of in many funds," Phillips warned. "Look 'under the hood' of every investment, realize there is a wide range of returns and seek diversity to lessen your risk."

Interestingly, Phillips has found that mutual funds offered by banks, while serving up fewer top-performing funds, provide more predictability and stability because banks realize their traditional investors won't accept volatility.

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