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Some saw market bust coming


IN 1995, A SMALL but vocal group of investment experts was predicting that the stock market bubble would burst.

Don Christensen was among the leaders of the band, largely through his book Surviving the Coming Mutual Fund Crisis (Little Brown). Christensen and others were preaching caution more than seven years ago. They were nervous that the bull market could not continue and that the bear was lurking.

They weren't wrong, just early. And that's why their voices were drowned out by the running of the bulls and by misguided but happy books like Dow 36,000, by James K. Glassman and Kevin A. Hassett (Three Rivers Press).

Early in 1995, I wrote about how investors could avoid Christensen's pending gloom.

Though I would suggest that the fund industry never went into the full-blown crisis mode suggested by Christensen's book, it certainly has had problems. Investors who took precautions and "lived by survival rules" back then would have avoided the problems that are more visible today.

That's why the book - and the defensive measures it suggests - are worth looking at now, when so many investors are trying to figure out whether the problem in their portfolio is with the funds they own or with the broader market.

"I still believe there is a coming mutual fund crisis," says Christensen, whose day job is running The Insider Outlook, a newsletter aimed mostly at institutional investors. "About 90 percent of [the book] turned out to be tragically correct, but if we updated the book, threw in new numbers, and changed just a few forecasts, it would be every bit as valid today as it was in 1995."

Adopting Christensen's survival rules - which would still work today - means:

Avoiding non-diversified funds. Focused funds were a new phenomenon in the mid-1990s, until the marketing pull of "a manager's best ideas" made them a hot commodity.

Concentrated portfolios can lead to good or bad performance, depending on the skill of the stock-picker. But they almost always lead to greater volatility, as anyone who bought focused funds before 1999 had undoubtedly discovered.

Avoiding high-risk investment strategies.

This included funds that trade in illiquid securities or "restricted shares," which frequently can't be sold for long stretches of time, as well as funds that use margin and short-selling and other speculative strategies in an attempt to goose returns.

When the "go-go funds" of the late 1960s became "no-go" funds in the 1970s, illiquid securities were part of the problem. The same thing has happened in the most recent downturn, with many fallen angels, such as the Van Wagoner funds, having been roasted by their most speculative positions.

Avoiding high-turnover, high-cost funds.

Christensen warned in the mid-1990s - and believes even more strongly today - that overactive trading and above-average costs make a fund wrong for the investor who is looking for a moderate and stable portfolio.

Reading proxy statements. The fund industry has cleaned up a lot of Christensen's trouble spots here, such as misnamed funds, by changing some rules that govern what funds are allowed to do.

Still, fund companies can get around those rules by having shareholders vote into place something management prefers. Moreover, proxy votes can signal that a fund is changing, which might not be a sell signal but certainly should put owners on alert.

Avoiding funds obsessed with the next big thing. Christensen's book was written before the advent of Internet funds, but it does point out that people who invest hoping to cash in on the next business revolution could find themselves paying a dear price. That's particularly true when a fund gives up on traditional evaluations - such as looking at balance sheets and evaluating investment histories - to buy what's new.

Dumping funds that could turn you into an insomniac. In 1995, Christensen was suggesting that investors drop any fund they owned in which a big market downturn would scare them to the sidelines. The same holds today for investors who are hoping for a market rebound but are prepared to eject if they get another backslide instead.

Christensen notes that it took about seven years for investors to go from the love affair of the go-go 1960s to disgust with mutual funds. If history repeats itself, he suggests, investors will soon reach the end of their rope with funds today.

"It's not about selling all your funds because there is a crisis coming," Christensen says, "but if people haven't learned by now that they have to be careful about how they pick and manage funds, then they haven't learned anything."

Charles A. Jaffe is mutual funds columnist at The Boston Globe. He can be reached by e-mail at jaffe@globe.com or at The Boston Globe, Box 2378, Boston, Mass. 02107-2378.

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