February 26, 1999

Mutual Funds

Study Finds Risk Adjustment
Is Necessary for Tech Funds

By PUI-WING TAM
Staff Reporter of THE WALL STREET JOURNAL

Mutual funds that specialize in technology stocks are shining atop the performance heap. A few funds are even posting triple-digit trailing 12-month gains. But is it too late to dive in? You're asking the wrong question. Timing isn't necessarily the issue here. It is risk. Because the stunning gains that beckon you aren't as great as they first appear after factoring in that four-letter word: risk.

Fueled by a frenzy over Internet stocks, investors have been pouring several hundred million dollars into technology mutual funds each week, according to figures from AMG Data Services. But amid all the hype, many investors may be forgetting that the risk inherent in the technology sector can ultimately take a huge bite out of a fund's final returns.

Just how different are the returns of technology funds after factoring risk into the equation? Take the $24 million Dresdner RCM Global Technology Fund. It tops the sector's three-year performance tables for the period ending December 1998 with an annualized total return of 37.2%. After adjusting for risk, the fund still stands at the head of the pack, but its return falls to 30.1% a year, compared with a 28.2% annualized gain for the Standard & Poor's 500-stock index of large companies over the same period. That's according to figures crunched by Leah Modigliani, a Morgan Stanley Dean Witter U.S. investment strategist who is an expert on risk-adjustment methodology.

"When evaluating performance, total return doesn't tell the full story," Ms. Modigliani says.

In a report to be released Friday, Ms. Modigliani uses a risk measure that she developed some years ago with her grandfather, Nobel Laureate Franco Modigliani, called the Modigliani-Modigliani measure, dubbed "M-squared," to examine 37 technology funds with track records of at least three years. She looks at how risky the technology funds are on their own, as well as how risky they are in the context of a diversified U.S. stock portfolio.

What exactly is this risk-adjustment methodology? Essentially, M-squared puts all funds on a level playing field of risk, or, as it is known in the investing world, "beta." Each fund's risk is adjusted to the beta of a market benchmark, in this case the S&P 500. How? By hypothetically blending shares of a volatile technology fund with Treasury bills and cash, to bring it down to the volatility level of the S&P 500, and by leveraging up a more conservative fund using borrowed money to raise it to the beta of the S&P 500.

In general, Ms. Modigliani found that technology funds, by themselves, are about 85% more volatile than the S&P 500. This isn't surprising -- technology stocks undergo tremendous day-to-day volatility, as shown by the price swings in Internet shares.

The good news: When a technology fund is placed in the context of an overall U.S. stock portfolio, the funds on average appear slightly less risky. Ms. Modigliani found that as part of a diversified portfolio, technology funds are only 35% more volatile than the S&P 500.

The results should caution investors about the dangers of putting all their eggs in one basket. In other words, if an investor stuck all his money into one average technology fund, he would likely be subject to volatility 85% greater than the S&P 500. But if an investor bought a technology fund to augment a wider-ranging portfolio, some of that technology fund's risk would be diversified away. As a result, measured by beta, the technology fund would on average be just 35% more volatile than the S&P 500.

How do individual technology funds stack up? As most tech funds take on more risk than the S&P 500, their returns were accordingly lowered when risk was taken into account, Ms. Modigliani found. Just as the total returns of Dresdner RCM Global Technology Fund dropped, so do many of the other top-performing tech funds.

Some other examples: Fidelity Select Computers, a portfolio with $2 billion under management, produced a three-year annualized return of 36.7%, but when adjusted for risk, the return dropped to 29.3%. Still, that was enough to make it the sector's second-best performing risk-adjusted fund.

Pimco Innovation, with $865 million in assets, produced a three-year annualized risk-adjusted return of 25.9%, down from 34.2% before the adjustment. And Fidelity Select Electronics, with $3.4 billion in assets, generated a risk-adjusted gain of 25%, down from 34.7%, the biggest drop among the top five funds.

In contrast, Franklin DynaTech Fund is managed relatively conservatively. While the $400-million fund produced a three-year annualized return of 23.4%, its risk-adjusted return actually rises, to 28.9%. That puts the fund in third place in terms of risk-adjusted return, behind Dresdner RCM Global Technology and Fidelity Select Computers.

Walter Price and Huachen Chen, co-portfolio managers of the Dresdner fund, say they attempt to manage risk by buying shares across a variety of tech sectors, as well as across country borders. But they feel that much of the volatility of the tech sector is beyond a manager's control.

"Intuitively, the beta and risk of the tech sector is high," agrees Mike Tempero, Fidelity Select Computers' manager.

Despite the current individual-investor mania for Internet stocks, most of the top-five tech funds are mindful enough of volatility to avoid holding large slices of these companies. Matt Grech, portfolio manager of Fidelity Select Electronics, says Internet stocks "have never been a meaningful part" of his portfolio. Meanwhile, Dresdner RCM Global Technology Fund has less than 10% of its assets in pure Internet plays.

"We believe that the Internet is a driving force for technology, but we're selective and buy just the leaders," says Mr. Price, the Dresdner RCM Global Technology co-manager. "There will be a major shakeout in that sector" at some point, he warns.

While Ms. Modigliani's study clearly brings the issue of risk to the forefront, John Rekenthaler, research director at Morningstar Inc., a Chicago fund-research firm, cautions investors to think about whether they should be investing in technology to begin with. "I'm not sure technology funds will make as much money over the next 10 years as they have over the past 10 years," he says.

But Ms. Modigliani counters: "Technology is what America does best." As investors continue to flock to tech funds, she urges investors to focus not on past total performance but factors including manager tenure, fees and style. Most importantly, "it's necessary to get a picture of risk when choosing a technology fund," she declares.

Adds Tracy McCormick, portfolio manager of $2 billion-in-assets Kemper Technology Fund: "When tech companies are successful, they're home runs. But there's a pretty high failure rate for some of these firms, too."

* * *

MOVING MANAGERS: Two high-rated managers of Boston's MFS Investment Management are leaving the firm to start their own hedge fund, saying they want the freedom to bet against stocks.

Chris Felipe, manager of Massachusetts Investors Growth Fund, and John Brennan, manager of MFS Capital Opportunity Fund, had helped MFS hit a hot streak. In particular, Mr. Felipe's fund, which invests in the large, fast-growing companies that have been leading the market, returned a sizzling 40% last year, according to Lipper Inc. Bolstered by its strong investment performance, MFS, majority owned by Sun Life Assurance Co. of Canada, racked up net sales last year of about $12 billion, among the top in the industry, said Jeffrey Shames, MFS chief executive and chairman. The company manages about $105 billion in assets.

Mr. Shames said the managers had become more bearish about the market's lofty level and wanted to be freer to sell stocks short -- or bet against individual companies. That's hard to do at a mutual-fund company but common practice at hedge funds, which are private investment vehicles for the wealthy. Stephen Pesek, who oversees the MFS Large Cap Growth and MFS Core Growth funds, will take responsibility for Massachusetts Investors Growth. Maura Shaughnessy, who manages the MFS Utilities Fund, will take over MFS Capital Opportunities Fund.

-- John Hechinger

TO STAY HEALTHY: Vanguard Health Care Fund, the nation's largest sector fund with $10 billion in assets, closed to new subscribers Thursday, Vanguard spokesman Brian Mattes announced. Mr. Mattes said the fund, which is managed by Edward Owens and is designed to invest only in health-care-related stocks, will enter "a cooling-off period" of at least six months to a year. The fund has been flooded with cash, leading to fears that it may now be loaded with too much "short-term, speculative money," according to Mr. Mattes, who said there are no plans to create a clone health-care fund.

-- Pui-Wing Tam

Money-Fund Assets Dropped $8.17 Billion

Money-market mutual-fund assets fell $8.17 billion to $1.455 trillion for the week ended Wednesday from a revised $1.463 trillion, the Investment Company Institute said.

Assets of the 920 retail-class shares decreased $573.8 million to $861.59 billion, the trade group said. Among retail-class shares, assets of the 568 taxable shares rose $235.5 million to $709.79 billion, while assets of the 352 tax-exempt shares decreased $809.3 million to $151.79 billion.

Assets of the 753 institutional-class shares decreased $7.6 billion to $593.69 billion. Among institutional-class shares, assets of the 589 taxable shares fell $6.17 billion to $544.82 billion, while assets of the 164 tax-exempt shares fell $1.43 billion to $48.87 billion.

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