End of The Comfort Factor

By Nancy R. Gibbs

As long as Wall Street was blooming, mutual funds seemed to promise the impossible: a place where cautious people could plant their money, ignore it and let it grow, as safely as in a bank but as fruitfully as in the stock market. Millions of new investors could not resist. Take Charles Jayson. Last year the Manhattan retailing executive bought 510 shares in a stock fund managed by Boston's Fidelity Investments (total assets: $75 billion). "I wanted to be in the market," says Jayson, 30, "but I wanted something I didn't have to watch every day."

Still, he could not help watching last month as the market withered and the value of his $8,700 investment fell to $6,600. "I didn't want to sell," he says. "I didn't want to panic." But he found himself constantly dialing Fidelity to check on his holdings. The line was usually busy. On Oct. 20, the day after Black Monday, Fidelity was fielding six calls a second. "Then it hit me: Why am I acting like this over mutual funds? They're not supposed to be exciting. They're supposed to be dull and safe." Though he did not sell, he is no longer sure his money is secure. Sighs Jayson: "The comfort factor is gone."

For America's 12 million shareholders in stock mutual funds, these are indeed uncomfortable times. Since the market peaked in August, the assets of equity-based mutual funds have fallen 21.1%, from $234.3 billion to $185 billion. That was a slightly worse showing than the market as a whole, as measured by the Standard & Poor's Index of 500 stocks, which fell 20.9%. Fidelity's flagship Magellan fund, worth $12 billion in August, has shed 31% of its value. Pioneer II, a $4.4 billion fund three months ago, has lost 25%.

Though seasoned investors vowed to wait out the market, many newcomers who had never heard a bear market growl found the sound just too menacing. During the last two weeks of October, shareholders drained a total of $13 billion out of stock mutual funds. Of that, $9 billion flowed into money-market funds, which hold Government securities, bank certificates of deposit and other sturdy investments. At Franklin Resources in San Mateo, Calif., redemptions in October reached $550 million, a level more than three times as high as in a typical month. "It was a stampede," said Monte Gordon, director of research at the Dreyfus group of mutual funds. "Everybody tried to run out the exit door at the same time."

Not all fund shareholders suffered equally when the market splintered. Though the term mutual fund is used to refer to any basket of investments that shareholders own jointly, some bushels contain more perishable ingredients than others. Hardest hit were people who gambled on high-growth funds made up of over-the-counter stocks in small companies. As the market shuddered, many investors quickly dumped such risky stocks and bought into blue-chip issues. Result: even when Wall Street tried to rally, the small stocks were left far behind. The worst performers among the high-growth funds included 44 Wall Street Equity, which has lost more than half its value since Oct. 15, and Security Omni and Leverage Fund, which each lost at least 38% of their assets. Many of the "sector funds," which focus on a single industry, also turned out to be a bad choice. Funds specializing in leisure-time goods, oil-service companies, electronics and automotive products fell an average of 30% to 40%.

Some equity funds managed to cut their losses because bearish managers had moved away from cyclical stocks, such as steel and tires, and into defensive shares in food and drug companies, which are less vulnerable in an economic downturn. Some funds that specialize in electric and telephone utilities dropped 12% or less. Other prescient managers had built up their cash reserves, which lowered their exposure to the market and allowed them to pay off any redemptions without being forced to sell stocks at a loss. Says John Neff, who manages the Windsor Fund: "We saw a correction coming, so we had plenty of gunpowder stashed away."

A few savvy fund managers actually came out ahead. The Oppenheimer Ninety- Ten fund rose nearly 8% in the last two weeks of October, largely because it invested in put options, which appreciate when stock prices drop. When the market started to recover, many fund managers began to scoop up bargains. Neff's Windsor Fund, for example, bought $800 million worth of stocks. "When everyone is panicking and stock values are depressed, of such circumstances are opportunities born," he says. "We are buying aggressively, and we will continue to buy."

But most mutual-fund companies could not take full advantage of those opportunities. Many exhausted their cash reserves and had to sell stocks or borrow from banks to meet redemptions. Even so, no companies were mortally wounded. Diversification helped large firms like Fidelity, which has 4.7 million accounts in more than 100 different funds. Some 98% of the customers who cashed in shares of Fidelity stock funds merely transferred the money into the company's other funds, including money-market accounts.

Over the long term, however, such switching could hurt the profitability of the fund companies, since money-market and bond funds bring in lower sales commissions and management fees than stock funds do. Most fund managers hope that investors, after a period of cooling their nerves, will venture back into the stock funds. Says Edward McVey, senior vice president at Franklin Resources: "As soon as people got over the initial trauma of Black Monday, they were calling up to reverse their redemptions." Michael Lipper, president of Lipper Analytical Securities, is not quite so confident. "The panic is over," he says, "but the jury is still out on the comfort factor." Fund companies have already launched a blitz of upbeat ads and letters to shareholders in an effort to convince customers that mutual funds are still a safe and lucrative alternative to the savings account -- or the mattress.

CHART: TEXT NOT AVAILABLE

CREDIT: TIME Chart by Cynthia Davis

SOURCE: LIPPER ANALYTICAL SERVICES, INC.

CAPTION: LOSING THEIR STUFFING

% DESCRIPTION: The ten largest mutual funds, in five categories. Color illustration: Pillow with dollar signs falling out.

With reporting by Thomas McCarroll/New York and Charles Pelton/San Francisco