Has your mutual fund changed its personality?

• Author: Longstaff, John S.

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...