Fund Coverage Requires Appetite for Knowledge

The mutual fund is the hot dog of the financial services industry.

Everyone eats it, but few people know what goes into it, and almost no one ever sees how it is made.

From the standpoint of a journalist trying to cover funds, therefore, the question is whether you are covering it like a food critic -- talking about the guilty pleasures of consumption and the tempting taste combinations someone can put together -- or like a health and science reporter, talking about the dangers of preservatives and other ingredients, plus the concerns about overeating.

The role you take depends on the story you are pursuing, but it also requires that you know enough to look much deeper than the average consumer in order to size up a fund.

Before explaining key elements to look at, let's consider the mutual fund business as a whole.

Depending on how you count them, there are between 12,000 and 20,000 mutual funds. The counting issue itself showcases some of the trouble reporters have when stepping into the fund beat. Technically, if you have the Smith Fund and it has Class A shares and Class B shares, you have two funds; the underlying investments are the exact same, but each share class represents a different payment style for the broker or adviser who sold it to the consumer.

The number of funds grows when you include closed-end funds -- which trade like stocks, and which are much more likely to get into the news due to management arguments and proxy fights than ordinary funds -- and exchange-traded funds, which typically mimic an index but trade like a stock (the popular SPDR or Spider and the QQQQ are examples of exchange-traded funds that track the Standard & Poor's 500 and the NASDAQ 100 respectively).

So when you start reporting on a fund, know what you are looking at. If Smith Asset Management is in your town and it has A, B and C share classes on its funds, and you are covering a manager change at Smith Growth, you must add together the share classes to say how much money the manager is running (if you use the research of Morningstar.com to examine total assets, all share classes are lumped together, so that each share class shows the exact same dollars in assets). If, however, Smith Asset Management decides to eliminate its B share class, you need to find out how much money specifically is in B shares.

With all of those funds out there, it is equally important to recognize that funds can be run from just about anywhere, including a kitchen table in the town you call home. Many financial advisers who only take on wealthy clients have created funds to help the children of customers get counsel on the cheap. Money managers can, effectively, buy a turn-key operation, managing the money while a service provider handles all regulatory and back-room requirements.

Now let's get back to the kinds of stories you are likely to encounter, and what you will need to know to play those food critic/health reporter roles.

In the critic/observer role, you effectively are looking at performance. The guilty pleasure here, of course, is recent results, focusing in on what has been hot in the last six months or year.

It may make for interesting reading, but it often leaves the investor with a bad case of indigestion.

Funds tend to heat up because they specialize in an area of the market that has gotten hot. Around the time they top the performance charts, their specialty is nearing the top of its run.

This is why it pays to look at funds in a number of ways, using more than just raw performance. Morningstar, Lipper, Value Line and CDA Wiesenberger all provide additional looks at funds, based on different formulas.

Lipper gives grades for consistency, total return, preservation of capital, tax efficiency and expenses. Morningstar and the others look at "risk-adjusted return," which measures whether the fund's gains or losses are appropriate for the amount of risk the fund takes.

While fund firms get excited about getting a five-star mark from Morningstar or a Lipper Leaders tag, journalists should not be nearly so enthusiastic. These are mathematical exercises, not judgment calls. A fund firm that puts a five-star rating in an ad is saying something, but if it puts exclamation points behind the stars it is assuming readers are idiots: This isn't a review like a hotel guide, it's the completion of a formula that put the fortunate fund in its top peer group � for now.

When looking at fund performance, be sure to benchmark the fund to an appropriate index and peer group. Funds typically show their performance against the Standard & Poor's 500, but that's only an appropriate measure for funds that buy large-cap stocks.

Moreover, recognize that a fund can look good and bad at the exact same time, thanks to the different categories used by each rating firm. It is possible for a fund to be rated as a mediocre large-cap fund by Morningstar, but a top-flight multi-cap core fund by Lipper.

When you go from covering the fund to covering the management company, worry less about how the fund scores for performance and more about how it makes that performance.

Funds list their major holdings, so it's easy to determine if a fund family you cover has major holdings in a stock that is in the news. That makes almost any stock blow-up an easy local story. When the next Enron happens, check to see which funds run by your local management company hold a big slug of it (if you can't find it, researchers at Morningstar or Lipper will be able to get it for you).

Likewise, you can use fund managers as another form of analyst on stocks of local interest. This can be particularly effective when you see a fund with a large slug of a big local employer. And if you check the fund's holdings regularly, you may get a story when a big fund shareholder decides it's time to get out.

What is much more difficult to determine is when a fund changes managers or service companies, as these items may not be reported in an ordinary prospectus.

Watch a fund's filings, particularly the ones that are unscheduled and just pop up when you do an EDGAR search. While these issues often cover minor tweaks in a fund, this can be where a fund company announces a management change, the closing of a fund to new investors and more.

Most funds -- or fund companies -- don't make news on a regular basis. But the stories you'll find by sticking it out and researching the business will be satisfying, kind of like a good hot dog every now and then.

Copyright © 2008 Donald W. Reynolds National Center for Business Journalism