When 'Safe' Funds Go Bad - TheStreet

When 'Safe' Funds Go Bad

Funds labeled 'utilities,' 'bond' and 'index' aren't always low risk.
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The wild ride that the stock market has taken this year may have many investors scrambling for the relative safety of mutual funds that have more of a conservative bent to them.

Bond, utility and broad-index mutual funds are among the investments commonly thought of as shelters from the market's gyrations. But fund watchers say look before you leap into that safety net: Many mutual funds that are considered more conservative plays will expose you to the same risks that a volatile tech fund carries.

The upshot: Don't judge a book by its title. Lurking within that seemingly staid utilities fund could be a heart of rocky telecommunications companies. And bond funds, those most often associated with steady, dependable incomes, could hold some high-yield debt that only the riskiest of investors would want.

Perhaps the greatest caveat to investors is that nothing is ever guaranteed with mutual funds -- and that is especially true with stock funds, says Bob Veasey, certified financial planner with the

Sowa Financial Group

in East Providence, RI.

"I have seen all too many times people who've never participated in market performance thinking that they can stick $10,000 into a mutual fund and

voila

," says Veasey. "This year has proved that that is not always the case."

Who would have thought at this time last year -- when many technology funds were yielding triple-digit returns -- that a year later we'd be looking at a market where Treasury bond funds were outperforming tech funds by as much as 44 percentage points? Probably not many.

Bond Funds

With their backing by the U.S. government, Treasuries are considered safe in that the government will, in all likelihood, not default on the securities. But Treasuries are sensitive to interest rate fluctuations, and the return on the bonds can vary depending on the interest rate environment. Further, even though Treasuries are outperforming some sectors of the stock market this year, Treasury funds have historically underperformed their stock counterparts.

"Although I consider a Treasury to be absolutely safe, it will, between now and five years from now, go through all kinds of undulations," says Veasey.

Shorter-term bonds are normally less interest-rate sensitive than longer-term bonds, but when buying mutual funds that invest in corporate debt, knowing the credit quality is key. High-yield bond funds obviously invest in junk bonds, but other bond funds could have healthy doses of speculative debt.

One example, the $2.2 billion

(STADX)

Strong Advantage fund, which invests in bonds with maturities of one year or less, currently has about 10% of its portfolio in high-yield bonds and 26% of its holdings in triple-B rated bonds, which are on the lowest rung of investment-grade status. A recent

Morningstar

analysis notes that the credit quality of some of the fund's holdings could make it too risky for those looking for a super-safe investment, but Tom Sontag, co-portfolio manager of the fund, disagrees.

"This is really kind of one baby step beyond a money market fund," says Sontag, noting that despite the lower-quality holdings, the fund's average credit quality is a single-A rating.

Are You Really Diversified?

When investing in equities meanwhile, planners and analysts say diversification is key to smoothing over the stock market's fluctuations, but pitfalls in that strategy can arise if investors own several different funds that each have some stakes in the same stocks.

"That's one problem we see a lot with some of the portfolios we look at," says Chris Staples, assistant vice president of mutual fund research at

Raymond James

. "You think you're getting diversification but you're not."

Changing Currents in Utilities Funds

The polar opposite of diversification is investing in sector funds, which essentially bet that one narrow slice of the market is going to outperform the rest. This is considered a rocky approach, since sectors generally go in and out of favor at different times, even though some segments of the market, like utilities, have traditionally been cast as conservative, steady investments.

The changing nature of the utility industry has altered that point of view, as competition has prompted many old-line utilities to become more technologically savvy, and high-flying telecommunications companies like wireless provider

Nextel Communications

(NXTL)

and Spanish telecommunications company

Telefonica

(TEF) - Get Report

, which has extensive holdings in Latin America, can now be found in many utility funds.

"The waters get kind of muddy because of the different business segments (utilities) are involved with," says Staples.

'Safe' Indexing

Even index funds are no guarantee of steady performance. Investing in the

S&P 500, for instance, will get you a broad range of stocks, but that index is still heavily focused on large-cap companies. So somebody invested in the S&P 500 and nothing else would miss out if there were to be a rally in small caps. And although the S&P 500 has posted impressive returns of 21.7% and 19.4% for the five- and 10-year periods, respectively, the index is down 1.4% year-to-date. Indexes that focus on technology or international stocks can be much more volatile than that.

"The perception is that if you have a broad enough index you have some safety," says Philadephia-based fund consultant Burton Greenwald. "In fact, some of the most volatile funds are index funds."

Of course, the point of investing is to make money, and no investment is absolutely 100% safe. But if you're more concerned with capital preservation than stellar returns, Greenwald says Treasuries, triple-A rated securities and money market funds are probably about as safe as it gets.

"The pitfalls are, the more you reduce the risk, the less you have potential for upside gain. It's a very simple equation," says Greenwald. "If you're risk averse, you're not going to get the rewards."