More funds playing a risky game

By The Wall Street Journal

In an effort to lure back investors still wary of stocks, more mutual fund managers are playing a risky game: timing the market.

Many of these funds promote their ability to avoid big losses by trading in and out of the stock market at just the right time. Some are labeled "tactical allocation" or "dynamic" funds. But even funds that don't openly tout such strategies are moving in and out of big cash stakes, betting that they can outsmart the volatile market.

Quaker Small-Cap Growth Tactical Allocation Fund (QGISX), launched late last year, now has about half its assets in cash, down from as much as 95% last year. The new John Hancock Technical Opportunities Fund (JTCAX) had about 12% cash at the end of October and is managed using a strategy that devoted roughly 90% to cash early this year. The 3-year-old Encompass Fund (ENCPX), which can invest in all sorts of U.S. and foreign stocks, has held more than 30% in cash in recent months.

These and several new funds from firms like Legg Mason and Morgan Stanley's Van Kampen Investments have leeway to make swings between cash and other investments.

But funds attempting to time the market often deliver erratic performance, charge high fees and rack up big trading costs.

Shining as fund world struggles

These funds are something of a bright spot for the fund industry, which has seen billions flow into bond funds but little cash go to more-profitable stock funds. Investors put $4.1 billion into world-allocation funds (Morningstar's category that tracks the most flexible funds) in the first nine months of this year, while adding only $4.3 billion to stock funds and plowing $213 billion into taxable bond funds.

Some of these funds have beaten the market in recent years. Ivy Asset Strategy (WASAX), for example, gained an annual 14.9% in the five years ending Nov. 10, compared with less than 1% for the Standard & Poor's 500 Index ($INX).

But they can also give investors whiplash. The Encompass Fund fell 62% last year, landing at the bottom of its world-stock category. This year it's leading its world-stock category with a nearly 110% gain.

Fund companies say investors spooked by the recent market turmoil are demanding more-flexible products. Many investors have been frustrated "with investment products that were not able to react to the environment that we just went through," says Joel Sauber, the head of U.S. products at Legg Mason. The company's new Permal Tactical Allocation Fund (LPTAX) can stash up to 40% in cash.

Can managers win this game?

A study from New York University's Stern School of Business suggests market timing can work for some mutual fund managers. The best stock pickers during economic expansions also show some market-timing ability in recessions, the study found.

But academic research raises doubts that the typical fund manager can successfully time the market over the long haul. Anders Ekholm, an adjunct professor at Hanken School of Economics in Helsinki, Finland, recently analyzed more than 4,000 U.S. stock funds' returns between 2000 and 2007. Managers helped their performance through stock picking, he found, but hurt their returns by market timing.

There are a couple of reasons why the deck is stacked against market timers, Ekholm says. Market timing requires more trading, and transaction costs hurt performance. What's more, while a manager may relatively easily dig up some unique information that gives him an edge in selecting an individual stock, it's difficult to get such superior information about the overall market.

Though some fund companies are promoting their new tactical-allocation funds as core holdings, analysts are skeptical. If the manager makes a wrong call, like plowing into cash before a market rally, "that could really hurt the investor," says Karin Anderson, a mutual fund analyst at Morningstar.

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Some managers moving in and out of the market rely on macroeconomic views. Others are simply bottom-up stock pickers who hold lots of cash when they can't find other opportunities. Then there's John Hancock Technical Opportunities Fund, which is guided purely by technical analysis, examining patterns in market data.

An unknown for investors

Given these managers' long leashes, it can be tough for investors to keep track of what they're doing. Legg Mason's new tactical-allocation fund, for example, has been in and out of five or six asset classes in the few months it's been on the market, Sauber says. Mutual funds are required to disclose portfolio holdings only every three months.

Even some funds with narrower mandates are shifting in and out of big cash stakes. Intrepid Small Cap Fund's (ICMAX) prospectus, for example, says it normally invests at least 80% of assets in small-company stocks. But amid the market turmoil, the fund regularly had very high cash stakes of as much as 40%, says manager Eric Cinnamond. The cash stake was down to zero in March but is now back to 14%.

Investors might believe such moves in and out of the market contributed to the fund's strong recent performance. But an analysis of Intrepid Small Cap's returns in the 18 months ended in September by investment-research firm Markov Processes International found that its outperformance was due to stock selection, and that the market-timing moves made almost no contribution.

Cinnamond says he's not trying to time the market, but "we're not going to knowingly buy overvalued securities just to be fully invested."

Funds dodging in and out of the market also tend to be quite costly. The A shares of Quaker Small-Cap Growth Tactical Allocation Fund charge annual expenses of 2.59%. The fund, which can move up to 100% in cash, has lagged behind more than 90% of its small-cap growth rivals over the past 12 months, gaining roughly 10%, according to Morningstar.

The expenses are high because the new fund still has relatively few assets, says Stephen Shipman, the fund's manager. "We're achieving what we set out to do for the investor," offering participation in up markets but avoiding much of the downside risk.

This article was reported by Eleanor Laise for The Wall Street Journal.