The Wall Street Journal-20080216-Mutual Funds Find an Enemy From Within- When Internal Vehicles Struggle- They Drag On Index Trackers

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Mutual Funds Find an Enemy From Within; When Internal Vehicles Struggle, They Drag On Index Trackers

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Fidelity Investments was so bullish about a group of internal mutual funds known as "central funds" that it invested heavily in them. Now outside investors are paying the price.

Dan Smith, a 61-year-old Norwood, Mass., software engineer, got an unpleasant surprise last month when he checked the performance of Fidelity U.S. Bond Index fund. It gained just 5.4% last year, lagging behind its benchmark index by 1.6 percentage points.

Mr. Smith keeps a close eye on his investments -- but his fund's troubles stemmed largely from another mutual fund that he'd never heard of. The U.S. Bond Index Fund had invested nearly 10% of assets as of Aug. 31 in Fidelity Ultra-Short Central Fund, one of a group of central funds that Fidelity Investments makes available only to its other mutual funds.

Troubles in one central fund can hurt many other funds. That is what happened when Ultra-Short Central Fund, which had exposure to troubled subprime mortgages, dragged down the returns of the $8.7 billion U.S. Bond Index fund and at least nine other Fidelity funds.

Mr. Smith, who is on the brink of semiretirement and devoted nearly 10% of his portfolio to the U.S. Bond Index Fund, sold all his shares of that fund in recent weeks. "I feel legitimately annoyed when an index fund misses its index by that much," he says.

A number of mutual funds are devoting chunks of their portfolios to other mutual funds as well as to exchange-traded funds, which resemble traditional mutual funds but trade on an exchange like a stock.

Of course, so-called funds of funds have long had a clearly stated strategy of investing in other funds. But many funds are being held by conventional funds where investors generally assume that the managers are personally selecting individual stocks and bonds for the portfolio. On top of that, the practice of funds owning funds often adds extra layers of fees for shareholders.

Fidelity defends the central funds. Owning them allows fund managers to diversify their holdings while focusing their research in particular market sectors and "that's where we feel we add the most value," says Fidelity spokesman Alexi Maravel.

Though Fidelity has been using central funds to help manage funds' cash positions since 1996, the firm in recent years has quickly expanded this arsenal of in-house funds. There are now 27 Fidelity central funds covering various stock and bond sectors as well as money markets, up from 10 at the start of 2006.

Use of the central funds is rising in many Fidelity funds. Fidelity Investment Grade Bond Fund, for example, had 51.5% of assets in bond central funds at the end of November, up from 16.5% at the end of July 2006. Fidelity Total Bond Fund's allocation rose to roughly 50% as of Nov. 30, up from less than 20% at the end of August 2006, while Fidelity Balanced Fund's allocation jumped to 19%, from roughly 3%.

But when one central fund stumbles, the tremors can be felt widely. The Ultra-Short Central Fund invested in subprime-related securities and fell roughly 2% or 3% in the third quarter, a disappointing performance for a fund whose prospectus says it "seeks to obtain a high level of current income consistent with preservation of capital."

It dragged down returns of at least 10 Fidelity funds sold to small investors, including Inflation-Protected Bond, Investment Grade Bond, Strategic Real Return and Short-Term Bond funds, according to the funds' annual reports.

Boyce Greer, Fidelity's president of fixed income and asset allocation, acknowledges such widespread fallout is a risk of using the central funds, but says the risk "is far outweighed by the benefits of having the expertise focused on a particular sector and being able to tap that expertise in a number of different portfolios."

Funds loading up on ETFs, meanwhile, sometimes charge hefty active- management fees for what is in effect a low-cost indexing strategy. Homestead Nasdaq-100 Index Tracking Stock Fund, designed to track the Nasdaq-100 Index, invests essentially all of its assets in PowerShares QQQ ETF.

Yet investors in the mutual fund pay total expenses of 1.7% of assets, while those who buy the PowerShares ETF directly pay just 0.2%. Peter Morris, the fund's co-manager, says that the fund makes sense for investors who don't have brokerage accounts and can't buy ETFs directly. The fund's expenses, he says, should come down as its assets grow.

When a mutual fund holds other funds, it can be difficult for investors to assess its true costs. Underlying fund fees often aren't included in the expense ratios that funds publish in annual reports. But starting in January of last year, mutual-fund prospectuses were required to show these "acquired fund" expenses.

Still, if funds are "using a lot of ETFs and trading quickly, you can never quite get your hands around what the costs are," says Karen Dolan, director of fund analysis at investment-research firm Morningstar Inc.

Funds buying other funds can also complicate investors' efforts to track exactly what they own and why. Mutual funds will generally list fund investments in their annual reports, but not what's inside those funds. And some mutual funds exclude fund investments from lists of top holdings. Vanguard Small-Cap ETF, for example, was a top holding of the Vanguard Explorer fund as of Dec. 31, but wasn't included in the list of Top 10 holdings on the firm's Web site.

Vanguard Group spokeswoman Rebecca Cohen says the firm excludes ETFs from lists of top 10 holdings because Vanguard funds generally use them to quickly put cash to work in the market, and "it doesn't give you really any insight into the manager's portfolio management style or where his primary concentrations are."

While investors who do some extra legwork can easily find ETFs' holdings and performance, it's not so simple to find details on Fidelity's central funds. Investors can find Fidelity funds' complete holdings, including those inside central funds, on the Fidelity Web site, but these lists don't show which holdings are inside central funds.

To find out just what the central funds hold, who manages them, and what their track record is, investors have to go trolling through lengthy Securities and Exchange Commission filings.

Even then, there's limited information available. Investors can get a snapshot of central funds' performance, for example, only every six months, through annual and semi-annual reports.