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Jewish World Review Dec. 26, 2001 / 11 Teves, 5762

James K. Glassman

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Consumer Reports

High-Tech Funds Low On Tech

http://www.NewsAndOpinion.com --
THE mutual fund, one of the great democratic inventions of the 20th century, seems to have gone astray. A mutual fund is a portfolio of stocks -- about 100, on average -- grouped around a theme. It gives two benefits to small investors: professional stock picking and broad diversification. For example, if you want to balance your holdings by owning shares in smaller companies, you can pick at least a dozen such stocks yourself (a difficult, time-consuming enterprise) or trust a good small-cap mutual fund manager to do it for you.

Unfortunately, many of the managers just can't be trusted. Last week, after I wrote about the importance of owning tech stocks, many readers complained that I failed to list good tech mutual funds to buy. It was a conscious oversight. There were no such funds. This week, I show why -- and then point out that there are some alternatives that do what funds should do but don't.

The best source for information about mutual funds is Morningstar, a mellifluously titled research firm based in Chicago with an excellent Web site (www.morningstar.com) as well as a hard-copy subscription service, available at many libraries, that examines funds in detail. I looked closely at the tech specialty funds that Morningstar ranked among its top five in two categories: "highest five-year return" (that is, the most profitable funds for investors) and "highest five-year rating" (a category that rewards both high return and low risk). Since there was overlap, I added a few more highly regarded funds. So I studied 12 in all.

The results were miserable.

I didn't expect high returns. Everyone knows that the past two years have been terrible for technology stocks. Last year, the tech-heavy Nasdaq composite index fell 39 percent. This year, it has dropped an additional 21 percent. So it was no surprise that the average tech fund would be down by more than half since the start of 2000, or that a large fund such as Waddell & Reed Advisor Science and Technology, which Morningstar gives its highest (five-star) rating, would be down 27 percent.

Losses aren't the problem. If you were investing in tech in 2000 and 2001, you should be down. But, as in the late 1990s, when other categories are down, tech will be up. The reason to own tech is to balance your portfolio and reduce its overall risk.

The problem is that, in an attempt to avoid losses, the managers of funds like Waddell & Reed decided not to invest all their money in tech stocks. Such an approach not only is deceptive, it also prevents investors from allocating their assets in a rational way. If you decide that you want to put 20 percent of your portfolio into tech, you expect a tech fund to own tech and only tech. Not so, Waddell & Reed. The fund's largest holding is Pfizer. Yes, the giant drug company. In fact, of W&R's top 10 holdings, five are health-care stocks, one is an energy stock, one cable, one telecom. Just three are traditional techs.

Certainly, the big pharmaceutical companies can be considered technology firms; they are major users of technology. Ditto, energy: Last month, I visited Exxon Mobil's research operation in Houston and saw amazing video models of underground geological formations, all generated by a supercomputer. But most investors own stocks such as Bristol-Myers Squibb and Apache (two big W&R holdings) in the drug or energy part of their portfolios. According to convention, these are absolutely not tech stocks.

Overall, health care represents 38 percent of the assets of the W&R fund, compared with proportions of 3 percent for semiconductors; 1 percent, computers; and 3 percent, software. No wonder Waddell & Reed outperformed 98 percent of its peers. It was playing a different game. And it had another advantage: The manager indulged in market timing by moving his money out of stocks altogether. The latest Morningstar report showed that only 77 percent of the fund's money was in stocks, the rest in cash. Another strong performer, Firsthand Technology Value, had only 81 percent of its assets in stocks; Kinetics Internet, just 76 percent.

Such a strategy may produce temporarily higher returns for managers who guess right, but the approach befuddles conscientious investors. Let me decide how much cash I want to hold. The tech part of my portfolio is for tech stocks, period. When you own a fund, you expect it to retain perhaps 3 percent or at most 5 percent of its assets in cash -- as a cushion against redemptions (or sales) by shareholders. But the average tech fund in September had 9 percent of its assets in cash -- an absurd situation.

Tech managers believe, cynically but probably accurately, that investors care about one thing only: returns. So if tech stocks are cold, tech managers dump their tech stocks. The fund's name guarantees nothing. For example, if you want to move a small part of your portfolio into Internet stocks, considering how beaten up they are, then don't choose Kinetics Internet Fund, despite its incredible record in 1998 and 1999, when a $10,000 investment rose to $94,000. At last report, the fund's two largest holdings -- representing more than one-fourth of its total assets -- were IMS Health, which provides market research to the pharmaceutical industry, and Liberty Media, a holding company with investments in video programming (Starz, USA Networks, Discovery, etc.). In fact, I couldn't find a clear Internet stock -- an eBay or a VeriSign, for instance -- among the top 20 holdings.

There are other problems, too: The turnover in fund managers is frenetic. Fidelity Select Technology just changed managers for the second time in the past 18 months. As Morningstar's analyst writes, "Such frequent shifts are common at Fidelity -- the Boston giant makes no secret of the fact that its sector funds are training grounds." When you buy a fund, you are really buying a manager -- someone whose style and past performance you admire. If the manager changes every year, how can you tell what you own? The three managers at Kinetics began in 1999 and 2000; the manager of Fidelity Select Software and Computers started last year, as did the manager of Waddell & Reed Science and Tech; Michael Matook over at PBHG Technology and Communications only nine months ago.

Fees are often sky-high, for no good reason. Waddell & Reed, for example, lists a front-end load (initial sales charge) of 5.75 percent, plus an expense ratio last year of 1.2 percent. Pimco Innovation has a load of 5.5 percent plus annual expenses of 1.3 percent for a fund that over the past five years trailed the Pacific Stock Exchange index by an average of 13 percent! Now, that's chutzpah.

Even more gall is displayed by North Track PSE Tech 100 Index, a fund that mimics the Pacific Stock Exchange technology index. While most index funds carry no load and annual expenses of half a percentage point or less (since there's no active manager to pay), this one charges a 5.25 percent load, plus annual expenses of 0.7 percent.

Each of the three Fidelity Select funds in the category has a 3 percent load with expenses around 1 percent. That's more reasonable, and, if I were forced at gunpoint to buy a tech mutual fund, I would go with Fidelity Select Electronics, with the highest returns among all the tech funds monitored by Morningstar over the past five years, a five-star rating, a record of finishing in the top half of its category for eight of the past 10 years and a portfolio that is -- incredibly! -- 100 percent tech, led by Texas Instruments, Micron Technology, Intel and Microsoft.

Tech managers are compulsive traders. The turnover rate -- that is, the percentage of the assets in a fund's portfolio sold each year -- last year reached 217 percent for the average tech fund. In other words, the typical stock was held for less than six months by a fund. Turnover for Dresdner RCM Global Technology was 451 percent. The results of this kind of attention-deficit disorder are excessive trading expenses and, often, bad choices. A manager who can't si t still is someone who shouldn't be investing your money.

Okay, I'll stop complaining. Here's the good news. Check out something called the Technology Select Sector SPDR, an exchange-traded fund (EFT) -- that is, a portfolio that trades on the American Stock Exchange as if it were an individual stock (symbol:XLK). It includes all 97 tech stocks among the 500 stocks that make up the Standard & Poor's 500-stock index. (SPDR, by the way, stands for Standard & Poor's Depositary Receipts, or Spiders, which constitute the exchange-traded fund for the U.S. large-cap market.)

The stocks are weighted according to their market capitalization -- their value according to investors. The fund is top-heavy. Microsoft, the top holding, represents 15 percent of total assets, and the four next-largest holdings represent 27 percent. But XLK, because it includes stocks listed on the New York Stock Exchange, such as IBM, AOL Time Warner and EMC, reflects the true state of the tech market better than a better-known ETF, Nasdaq 100 Index Tracking Stock (symbol: QQQ), which is dotted with non-techs. Unlike managed mutual funds, XLK charges expenses of just 0.28 percent a year -- although, of course, you have to pay a brokerage commission to buy shares.

Don't get me wrong. I am not a down-the-line index kind of guy. I believe that smart fund managers can beat the averages. But, judging from the sorry state of tech funds today, it's good to know there are alternatives like XLK, QQQ or a bunch of stocks you select yourself.


JWR contributor James K. Glassman is the host of Tech Central Station. Comment by clicking here.

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