Originally created 02/21/99

'Relativism' comes to mutual funds



NEW YORK -- The name may be the same, and the management team, too, but there may be something different these days about the way your stock mutual fund is managed.

It's a subtle distinction, not easily pinned down -- and many fund managers insist they haven't changed a thing.

Yet several respected commentators have spoken up on the subject lately, and the issue merits your attention if you have any serious interest in stock funds.

The phenomenon is sometimes called "closet indexing" or "benchmarking" or "investment relativism," to use the phrase of John Bogle, senior chairman of the Vanguard Group, which runs the nation's second-largest fund family.

It refers to a tendency to manage a stock portfolio not for absolute return but constantly against the model of the Standard & Poor's 500-stock composite index, a market standard that has been hard to beat in recent years.

As the blue-chip stocks that dominate the S&P 500 have flourished, most fund managers who own portfolios laden with smaller and medium-size stocks have failed to keep pace.

Motivated by self-preservation instincts, at least some of those managers seem to have adapted their style to keep their portfolios more closely attuned to the 500, hoping to beat it by a few percentage points over any measuring period.

"Managers are extremely benchmark-sensitive, because they have learned that the S&P 500 is a formidable opponent," says Byron Wien, the well-known U.S. investment strategist at Morgan Stanley Dean Witter & Co.

"They have also learned that funds that beat the index enjoy healthy flows of new cash, and those that lag seriously behind suffer redemptions. So it is good business to be aware of the fund's positions relative to benchmark weightings.

"Portfolio managers used to pick stocks in order to achieve superior absolute performance, thinking that if they were good they would have no trouble beating the index," Mr. Wien observed in a recent commentary. "Now many keep a substantial portion of their portfolios in line with the index, while investing 25 percent to 50 percent creatively depending on their level of conviction.

"If they are right, they can pick up a few percentage points of relative performance and compare favorably with their competitors. If they are wrong, they shouldn't fall too far behind the index."

Mr. Wien sees both good and bad in all this.

"Money management has become much more of a business and less of an art form. Since you are dealing with people's retirement assets, this is perhaps as constructive as it was inevitable," he said.

He wonders, however, if it might drive the most-talented managers away from mutual funds toward other fields, such as hedge funds, where they could enjoy greater freedom to operate.

Mr. Bogle, famous for his outspokenness, takes a negative view. "In the long run, investors will not be well-served," he writes in his forthcoming book, Common Sense On Mutual Funds.

"The benchmark supplants judgment. Portfolio managers invest not on the basis of analysis and conviction, but in relation to a market standard, gingerly shading the weights of their portfolio holdings somewhat higher or lower than those of the benchmark. In recent years, it seems to me, this strategic approach has become almost tacitly accepted.

"Isn't that philosophy the antithesis of professional investment management? Yet hasn't it become the formula followed by nervous portfolio managers anxious to hold their jobs? Isn't it the result of the marketing department's holding sway over the investment department? In each case, my finding would be: Guilty as charged."

Whatever you think of this trend, it's easy to see how it came about. Fund managers' customers, competitors and the financial news media constantly are holding them to the standard of the S&P 500, applying pressure that is almost impossible to ignore.

Closet indexers may run into trouble if the day ever comes when S&P 500-type stocks lag the rest of the market and independent thinking starts taking the performance prizes again.

But for now, it seems, they are giving the customers only what they demand.