BC-WSJ--Mutual Funds-Cash,2008

When mutual funds don't want your cash

Eds: Via AP

By DIYA GULLAPALLI

SAN FRANCISCO -- One morning in November 2003, 15 Dodge & Cox senior managers gathered in a conference room here to decide an issue brewing for years: Was it time to close the flagship Dodge & Cox Stock Fund to new investors?

For months, senior managers had stood in the hallways and gathered in glass-paned offices, questioning what long had been a point of pride in the mutual-fund world: huge sums of money pouring in for investment. It became "a water-cooler kind of issue," recalls Kenneth Olivier, the firm's president.

Dodge's managers reached the unanimous decision in less than two hours. In January 2004, the firm closed the then-$30 billion flagship fund to new customers, while keeping it open to existing investors. Eight months later, it closed a sister fund, Dodge & Cox Balanced Fund, which invests in stocks and bonds.

The low-profile firm was on the cutting edge of a trend in the mutual-fund world: the proliferation of megafunds, portfolios swollen almost beyond recognition as investors chase their winning results. Even as Americans come under criticism for not saving enough, there is an embarrassment of riches at the hottest-performing mutual funds. Research firm Morningstar Inc. lists nearly 60 mutual funds with assets topping $10 billion, up from 47 in 2001. Of these, about 10 are closed to new accounts, including Fidelity Contrafund, Vanguard Primecap Fund and T. Rowe Price Mid-Cap Growth Fund.

This unprecedented cash surge creates a dilemma. Fund firms struggle between their vested interest in raking in new dollars and management fees, and their obligation to maintain strong returns for existing investors. Smaller funds require fewer winning stock picks to beat their bogeys, while swollen ones can mean positions so big in some stocks that it becomes hard to buy or sell without moving the price. At $56.5 billion, Dodge & Cox Stock Fund is 10 times its size in 2000, as it began the run of outperformance that attracted so much of the new investment. It is the nation's 10th-largest mutual fund. The balanced fund is $24.6 billion, about five times its 2000 size.

Dodge & Cox faced these issues in magnified form. It has only four mutual funds. The first was launched in 1931, and the company has added new ones almost begrudgingly. Priding itself on low costs and long-term investment results, it spends no money on advertisements in newspapers or on TV, or on marketing and commissions to securities brokers. Yet among the 15 largest fund families, it saw the biggest percentage increase in money under management in each of the past four years, according to Morningstar. It has about $110 billion in its mutual funds and $70 billion in accounts for pension plans, other institutional investors and wealthy individuals.

The two Dodge funds have continued their outperformance since shuttering, with smart calls on out-of-favor blue-chip stocks and energy shares. But Morningstar notes that there are fewer "lip-smacking" opportunities for the flagship Dodge stock fund, and "size will always be a challenge." Dodge acknowledges the issue head-on in letters to shareholders, trying to temper expectations for a fund that has beaten the broader market since 2000 and returned an average 12 percent annually over the past five years.

Dodge also faces some other issues: In December, longtime Chief Investment Officer John Gunn became chief executive, and a new president and executive vice president were named. Another CEO switch could occur when Mr. Gunn turns 65 in 2008. That would be a relatively large amount of turnover for a firm that has had only five CEOs in its history.

Van Duyn Dodge and E. Morris Cox founded Dodge & Cox in 1930, after working at financial firms during the go-go 1920s. They were disillusioned by brokerages making money from transactions, rather than from client returns. They thought long-term, using fundamental research to identify solid companies at reasonable prices. Turnover of stocks was low -- and still is: The firm holds stocks on average eight years. Many of its senior managers, meanwhile, have nearly a quarter-century with the firm. Mr. Cox came into the office until he was 94 and died at age 100 three years ago.

It is a closely held firm owned by 53 employees. There are no placards outside the doors or titles on business cards. Teams run the funds, and new funds are added only after elaborate consideration. The newest one, five-year-old Dodge & Cox International Stock Fund, went through a multiyear vetting period in which staffers researched foreign firms, ran a mock portfolio and put some of their own money at risk before offering the fund publicly.

"We don't want to focus too much on growth," Mr. Olivier, 54, says. "If you start going down that route," it would change the way the firm operates, making it more "an asset gatherer" than a stock picker.

The heady times now enjoyed by the firm were hard to imagine in the late 1990s. While its offices aren't far from Silicon Valley, Dodge largely sat out the tech-stock boom. "We weren't terribly popular, especially at cocktail parties," Mr. Gunn said in a 2003 interview. "But the valuations on the tech stocks were so outrageous, there was no debate." The flagship fund trailed the Standard & Poor's 500-stock index by more than 20 percentage points in 1998, and net withdrawals reached almost $500 million in 1999.

Dodge & Cox Stock Fund turned a corner as tech stocks and the broader market sank, returning 16 percent in 2000 and 9.3 percent in 2001 as its bargain-hunting investment style was back in vogue. Investors pumped cash into a fund they previously deemed too stodgy.

As early as 2002, the fund started "putting on the brakes," Mr. Olivier recalls. It raised the minimum on institutional separately managed accounts to $75 million from $40 million. But the tamping down wasn't enough, as the fund's outperformance continued into 2003. Meanwhile, another force was driving money its way: a regulatory crackdown on the special trading privileges many fund firms had given big investors, allowing them to dart in and out of funds more frequently than ordinary shareholders. Dodge & Cox wasn't among the many money managers implicated in the high-profile investigations.

Consultants called weekly with corporate clients wanting to move their 401(k) retirement programs to the firm. Three client-service representatives scrambled to write memos for senior managers. The flagship fund was buying more shares of its favorite stocks to fill up the ever-growing portfolio, and Dodge's traders were voicing concern about putting this new cash to work. The company started boosting its fleet of research analysts and assistants, from 20 in 2000 to 30 by 2005.

In mid-2003, the firm quit accepting new money from institutional clients. Net new money was on pace to top $9.5 billion for the year when the 15 senior managers in November 2003 walked past portraits of the firm's founders to gather in the conference room. Their decision, in effect, had been sealed in the prior hallway chats: The flagship fund would stop accepting money from new clients. It would keep taking money from existing shareholders, and would allow 401(k) accounts to continue to offer the fund to their employees.

"Everybody knew there was a point when we were going to have to make this decision, and the acceleration of money coming into the firm just got everybody on the same wave length," says Harry Hagey, 65, the firm's prior chief executive.

Still, "it was a decision that I think we were surprised we were ever going to actually be discussing," Mr. Olivier adds.

The managers decided to make the announcement and close the fund as soon as possible, to avoid a gap that could attract a last-minute rush of new money. As it turned out, they needed six weeks to coordinate with brokers and draft a letter to shareholders. The closing took effect Jan. 16, 2004.

As is typical after new investors are shut out, the existing ones kept sending in money: The flagship fund received $7.15 billion in net new money in 2004. With staff approaching its current 153, Dodge moved from the Citicorp Center to bigger quarters. The new space at the top of the Bank of America building is twice the size of the old location, with a larger trading room and empty offices for future analysts and operations staff. The decor is sleek granite and walnut with ample views of the Alcatraz prison and the Golden Gate Bridge.

A closure is often a tip-off that a fund has reached a size that makes it difficult for managers to take big enough positions in their picks to improve performance, according to Morningstar. But the flagship Dodge & Cox fund returned 19.2 percent in 2004, roughly double the broader market. As in the prior several years, some big winners included stocks from the "midcap" world, generally defined as shares of market capitalization between $1.5 billion and $5 billion.

The issue now is how much longer the fund will outperform. To put the new money to work, the managers boosted the number of stocks in the portfolio, to 86 from 79. Some big positions have taken longer to unwind; for instance, it took three months to sell off a 13 percent stake in Nordstrom Inc.

As Morningstar cautioned in a November 2005 analysis, "the portfolio's girth makes it harder for it to establish significant positions" in the midcap arena. Morningstar also noted that, at the end of the 1990s, "there was a stark disparity between the valuations of large, high-flying 'new economy' stocks and more traditional equities ... There aren't as many obvious bargains in the current environment."

"Yet," it concluded, "this fund is capable of handling these challenges."

Dodge officials acknowledge some midsize stocks are off limits: Analysts are discouraged from looking at companies with market caps less than $2.5 billion. But "midcap or large-cap, it doesn't make any difference to us," Mr. Gunn says.

Charles Pohl, 48, who co-heads research, says the stock pickers gravitated to midsize companies in the late 1990s in reaction to big stocks "getting expensive," not from unfamiliarity with big companies. Its analysts have researched Wal-Mart Stores Inc., for example, for two decades. Wal-Mart now is a big holding, along with McDonald's Corp. and Pfizer Inc.

Last year, the fund's 9.4 percent return just missed doubling the S&P 500's 4.9 percent total return, including reinvested dividends. But Dodge officials agree with Morningstar's broader point: The firm does "not expect these favorable long-term returns relative to the S&P 500 to be repeated," as it writes at the top of the flagship fund's 2005 letter to its shareholders. The letter points to misses like beleaguered auto-parts maker Delphi Corp., which it sold at a loss of 96 percent last year and is under bankruptcy-court protection.

Unlike Mr. Hagey who shunned the spotlight, Mr. Gunn often speaks at mutual-fund forums and investor conferences. The ruffled-hair Mr. Gunn resembles a college professor, wearing gray pants with yellow pinstripes, a light orange shirt and a yellow tie with zebras one recent day. His feet on a chair, he quoted 20th century Austrian economist Joseph Schumpeter when talking about media stocks, noting "capitalism is revitalized by waves of creative destruction." Ancient Asian artifacts, like a pink stone statue from a 14th-century tomb, adorn the office.

As for the flagship fund's future, Mr. Pohl said as he and Mr. Gunn sat at a conference-room table, "the fact that we have outperformed" since closing to new investors, "I think is proof" that the decision was made at the right time.

"So far," Mr. Gunn added, half-jokingly.