Has your mutual fund changed its personality?

USA Today (Society for the Advancement of Education), Jan, 1996 by John S. Longstaff

Most people probably have met someone who, at first impression, displayed a certain type of personality - only to discover later that person was quite different. Mutual funds can be like that; some appear to be one thing when, in fact, they're something else, or their personality changes over time.

Unlike people, however, mutual funds do not have good or bad personalities. What is important for investors is to select the funds whose "personalities" match their individual goals, objectives, tax situation, and tolerance for investment risk. For instance, if you're young and investing for retirement well down the road, you may prefer the dynamic personality of an aggressive growth fund that primarily seeks to increase its share price by buying fast-rising new companies. If you're a more conservative investor or a retiree seeking primarily current income, you may want the button-down personality of a growth-and-income fund or a government bond fund.

The challenge today is that independent studies, and a few headlines, have shown that many mutual finds are not always what investors perceive them to be. One example that made news recently involved a well-known institutional government income fund. To its shareholders, "government income" implied a conservative, safe fund owning primarily U.S. Treasury securities. In reality, the fund was invested heavily in a more speculative class of mortgage-backed securities. When interest rates rose during 1994, the fund lost more than 20% of its net-asset value within a few months.

Two major components define the personalities of mutual funds. First, what objective does the fund's prospectus say the fund is trying to achieve for its investors? Generally, this means one of three things: current income from interest or dividends, growth through long-term gains in share price, or a combination of income and growth.

Second, how does the fund intend to achieve its stated objective? If seeking income, does it invest primarily in bonds and, if so, what type of bonds? Or will it invest mostly in the stock of companies that pay out high dividends? If looking for growth, does the fund emphasize the stock of small, medium-sized, or large companies? Will it invest mostly overseas, in real estate, in gold and silver? Will the fund try closely to track a broad index such as the Standard & Poor's 500 or focus on a specific sector of the economy such as technology or financial services? Or does the fund have a wide latitude to invest in whatever it sees fit as long as this achieves the stated objective?

Based on its objective and policies for reaching that objective, each fund is placed into one of about 20 categories - such as aggressive growth, growth-and-income, international, index, fixed-income, and money market. A fund's name also may suggest what type it is.

This is where things may get sticky for investors. A rose may be a rose by any other name, but a mutual fund by a different name or classification can be misleading. A study by a Harvard University student, Erick Witkowski, now with Northfield Information Services, found that 56% of the mutual funds he analyzed were miscategorized. Economists Stephen Brown of New York University and William Goetzmann of Yale University found that just 35% of 282 funds listed as growth funds by a mutual fund rating service actually should have been listed in that category. They argued that 17% of those funds belonged in a higher-risk category of small-company funds.

Having a "misleading" personality doesn't necessarily mean a fund will perform poorly. One top-performing fund characterized as a growth-and-income fund - Oppenheimer Main Street Income and Growth Fund - returned 24.3% annually the past five years. However, the fund appeared to have achieved that success by emphasizing growth, not income. Its income was a mere 2.1% - low for conservative investors who bought the fund primarily for steady income.

So how can you identify the real personality of a mutual fund, or whether its personality has changed since you bought it? * Never invest in a fund based solely on its last year's performance. * Never pick a fund based only on its name or categorization. * Read the prospectus carefully. It may state the minimum and maximum percentages of a particular type of asset the fund will invest in, or the guidelines may allow a lot of leeway. The wider the latitude, the greater the potential that returns and risk may deviate from your expectations and needs. * Pay particular attention to the actual investment holdings listed in the annual and semi-annual fund reports. Two funds investing in 60% stocks and 40% bonds might be classified as "balanced" funds. Yet, while one focuses on conservative blue chips and high-quality bonds, the other may bet on more speculative small companies and higher-risk junk bonds. * If returns are unusually higher or lower than the average returns for its peer group, that may be a sign the fund belongs in another category. Experts caution that some funds intentionally misstate their category in order to stand out among their more conservative peers. * Follow a fund carefully if it changes managers. The new regime may bring a different style of implementing policies and achieving objectives, especially if the fund gives the manager enough latitude. * Watch the fund size. For instance, new investment money may pour into a particularly successful fund that focuses on small, high-growth companies. The flood of money may force the fund to invest in larger companies or hold larger amounts of cash, thereby changing its original personality