How Cisco Killed Everything

On the night of Cisco's(CSCO Quote) landmark earnings disappointment last week, we told you it was going to whack your Cisco and tech-stuffed funds, but now even we find the fallout pretty sobering.

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The whole idea of investing in a mutual fund is that it spreads your money broadly among many stocks, so your assets aren't pegged to the fate of just one company. But that's one of the many rules that Cisco breaks. A week ago the networking behemoth, which has managed to buy enough competitors to keep growing like a burgeoning small-cap despite its girth, told the world that it earned less than Wall Street analysts expected in its second quarter due to slowing demand, and admitted it might be entering a blue period for a quarter or two. It was Cisco's first earnings disappointment in three years, and a shot heard round the fund world, illustrating the scope of the company's influence and funds' vulnerability to weakness in their favorite stock.

In January, big Cisco holders like tech funds, telecom funds, big-cap growth funds and the Nasdaq 100 were all in the black, but after Cisco's disappointment thumped their shares, all are in the red for the year. Over the last week, tech funds, telecom funds and big-cap growth funds are the worst performing fund categories, losing 8.8%, 6.5% and 3.4%, respectively, according to Morningstar.

Who Turned the Lights Out? Cisco's plummet in February pulled down the returns of several major fund categories

Source: Morningstar. Returns through Feb. 13.

To understand why these funds tumbled so quickly, you need to understand the depth of fund managers' love for Cisco's shares, which have averaged a 43% gain over the last five years, beating the S&P 500 by more than 26 percentage points.

Some bought the stock because it's the market leader in the thriving networking space. Some bought the stock because it comprises more than 2% of the S&P 500 and not owning it was a big bet against the benchmark. The bottom line is that they bought shares in droves.

"Cisco was pretty much a must-own for many funds," says Morningstar senior analyst Christine Benz. "I think it was a rare large-cap growth fund that didn't have exposure to the stock. Also for large-cap blend funds, too, since many of those need a very good reason for underweighting a big part of the S&P 500. I think even to value managers playing catch-up, Cisco looked like the one quick fix they could trust."

Indeed, more than 75% of big-cap growth and big-cap blend funds owned shares at the end of January, according to the most recent portfolio reports submitted to Morningstar. In total, nearly 1,200 funds own Cisco shares, adding up to an 18% stake in the company.

Let Me Count the Ways Few stocks are as beloved by fund managers as Cisco

Source: Morningstar. Data through Jan.31.

If Cisco's pain were limited to its shares alone, it would be easier for funds to shrug off. But when the once bulletproof shop fell victim to a slowing economy and dipping corporate tech spending, it gave investors reason to worry about other companies' prospects. Firms like Applied Micro Circuits(AMCC Quote), Sycamore Networks (SCMR Quote) and PMC-Sierra(PMCS Quote) fell, too.

For an idea of the ripple effect, consider Cisco's effect on the tech-laden Nasdaq 100 Index where the networker's shares are a 6.4% position. From Jan. 1 until Cisco's announcement, the Nasdaq 100 was up nearly 6%; since then it has fallen more than 7%, dragged down by Cisco's 17.3% tumble, according to Thomson/Baseline Financial. The index's fall has real consequences because it's tracked by Nasdaq 100 Trust Shares(QQQ Quote), an exchange-traded fund where investors have more than $23 billion invested.

Furthermore, a look at the Cisco-heavy funds we highlighted on the night Cisco announced its miss shows how much one stock can rattle a fund's performance. Consider the broker-sold (MFEGX Quote)MFS Emerging Growth fund, a big-cap growth fund with $15.5 billion spread among more than 300 stocks. At the end of last year, the fund had 9.8% of its assets in Cisco shares. Though it was up more than 7% this year prior to Cisco's announcement, that year-to-date gain is now down to just 1.2%, according to Morningstar.

They've Loved and Lost How the funds that were most concentrated in Cisco have fared this year
Fund	% Assets in CSCO	YTD Return as of Feb. 5	YTD Return as of Feb. 12
(IINTX Quote)Investec internet.com Index	14.1%	4.2%	-4.7%
(RYIIX Quote)Rydex Internet	12.7	10.3	1.2
(SWTFX Quote)Schwab Technology Focus	10.3	11.1	1.9
(PTSGX Quote)Pitcairn Select Growth	10.2	3.4	-1.6
(MEGBX Quote)MFS Emerging Growth	9.8	7.7	1.2
(PASGX Quote)Phoenix-Engemann Focus Growth	9.4	0.9	-6.6
(CAPVX Quote)Capital Value	9.2	4.1	0.8
(HTEAX Quote)Heritage Technology	9.1	5.7	-3
(ROPPX Quote)Reynolds Opportunity	8.6	2.9	-4.5
(ETTIX Quote)E*Trade Technology Index	8.5	9.9	0.6
Nasdaq 100	6.4	5.4	-2.2

Of course, this doesn't mean fund managers weren't smart to buy Cisco and that they're dumb now to have hung onto it. After all, it made both them and you a lot of money over the past few years, and one or two rough quarters aren't necessarily reason to abandon ship. Instead, Cisco's miss reminds us that even "must-own" stocks fall from grace, and that it makes sense to look under your funds' hoods to make sure they aren't all loving the same stocks. If they are, you might be buying the same fund five times, rather than buying five different funds.

Much as we'd like to think our funds are kinder, gentler stock investments, they're going to take their lumps like everyone else when the market darling takes a tumble.

The Junk Pile

Fund marketers take a lot of heat for pushing ill-conceived funds, but they might be one of the better contrarian indicators out there.

Back in October, this column noted that in the 1990s, whenever fund companies launched a record number of rookies in a given sector-fund category, that category lagged the S&P 500 the next year. Last year, fund companies rolled out a record 39 new tech funds, according to Morningstar. So far this year the average tech fund is down more than 5%, compared to a 0.3% dip for the S&P 500. Over the last 12 months, just 3% of the tech fund pack are above water. Three-quarters of all tech funds are less than three years old.