Who Wants to Make Their Own Fund?

WHAT DO YOU get when you cross a mutual fund with a brokerage account? You may soon find out, as an increasing number of financial-services firms — including, most recently, Fidelity Investments and Charles Schwab (SCH) — are marrying the two. The resulting products, often referred to as stock baskets or create-your-own funds, aim to provide investors with the diverse group of holdings found in a mutual fund, but with the tax-efficiency and transparency associated with individual stocks.

The new products seem even more appealing in the wake of last year's market, which left many fund investors with negative returns and taxable distributions. And unlike exchange-traded funds, or ETFs, they can be customized by investors. Depending on which company is offering the basket, investors can either build their portfolios from scratch — picking their own stocks from the market at large — or choose from a menu of stocks assembled by the investment firm. Why not just go out and buy the stocks yourself and stick them in a brokerage account? The baskets offer significant savings in trading costs, and, in the case of the set menus, a lot of winnowing and investment guidance.

Compared with traditional mutual funds, all these investments offer much greater transparency. Since they create their portfolios, investors will know precisely what stocks are in them, whereas mutual funds are required to disclose their holdings only twice a year. In addition, investors in create-your-own funds, unlike mutual-fund investors, will know exactly how much they're paying in fees each month. But the tax benefits are what may ultimately hook investors, since they — rather than a fund manager — choose what to sell and when, and can thus control tax-efficiency.

With the entrance of powerhouses Fidelity and Schwab, the genre could take off. But investors just might want to wait on the sidelines for a while longer.

Until now, the players offering such investments have been few and small. Last May, former SEC Commissioner Steve Wallman launched Foliofn, which remains the best-known purveyor of these products, though BuyandHold.com and Sharebuilder.com actually launched earlier, in late 1999. Last summer, E-Trade Group (EGRP) and start-up Netfolio unveiled plans to follow suit, but Netfolio has since postponed its start to March 5, and E*Trade's product, originally scheduled for year-end 2000, has yet to debut. Now, with the entrance of powerhouses Fidelity and Schwab, the genre could take off. But investors just might want to wait on the sidelines for a while longer. For all the ballyhoo about the arrival of the investment giants into this market, these create-a-funds are still very new. As a result, the offerings, and their benefits, appear to vary greatly from company to company — and, in the case of the latest entrants, remain pretty unclear.

Schwab, for example, began testing its new product, Portfolio Source, at the end of 2000. The program is being offered solely at Schwab branches in Washington, D.C., while the firm explores whether to introduce it more broadly, says spokesman Glen Mathison. Portfolio Source is so far limited to two lists of 10 stocks, selected by U.S. Trust analysts to accomplish different investment objectives. What if you want to buy just a few of the 10 stocks on the lists? "We would not want them to do that and we're going to have a conversation about that," Mathison says. In fact, investors are encouraged to adhere not only to analysts' initial recommendations — but to subsequent revisions. While it's not clear what the consequences of a refusal to go along with the recommendations would be, any such "encouragement" could obviously deprive investors of tax efficiency.

Since the details haven't yet been outlined, it's tough to say what benefits you might reap should Schwab expand the program to your neighborhood. Significantly, however, D.C. investors must cough up a $10,000 minimum investment (by contrast, Foliofn requires no minimum) and pay an annual fee that Mathison declines to specify.

Fidelity's program is still being planned. It will be run out of its brokerage arm, says Tracey Esherick, executive vice president of the company's online-brokerage group, and will be geared for investors who trade at least 36 times a year. Fidelity and Lehman Brothers analysts will select baskets of perhaps 20 to 50 stocks in various sectors and reflect different investment styles. Fidelity says that the program, which will be introduced around June, actually represents a return to a failed attempt to offer sector-trading baskets in the late 1980s. "That product was really ahead of its time," says Esherick, adding that today there's "this whole group of active traders who are always looking for some thoughts on what sector to buy and what style to buy."

Fidelity hasn't settled on a minimum investment, but says it will be more than $5,000. Fees, too, are up in the air.

Foliofn's fees are a flat $295 a year for three Folios of no more than 50 stocks each. Alternatively, investors can use Foliofn for $29.95 a month if they don't want to commit to an annual subscription. Either way, trades made at other than its twice-daily trading times — 10:15 a.m. and 2:45 p.m. — cost $14.95 each. Investors can pick their stocks all by themselves, or choose from portfolios such as the Large-Cap Growth Folio and the Technology Folio. For its part, Netfolio plans to charge $199.95 a year for an unlimited number of its Personal Funds, as long as at least $5,000 is invested in each. Trades made after the initial purchase will cost $20 apiece, except for a free annual balancing.

Sound confusing? While the advent of the create-your-own fund is sparking investor interest, "whether people will understand it or not is another question," says Paul Fullerton, an analyst with mutual-fund consulting firm Cerulli Associates. As a result, he suggests these may be niche plays for self-directed investors.

Marcee Yager, a certified financial planner with Sterling Wood Financial in San Jose, Calif., worries that small investors won't get the diversification they need with stock baskets, particularly a 10-stock basket like the one Schwab is experimenting with or the baskets of as few as 20 stocks that Fidelity is talking about. Even potential savings on trading costs and capital-gains taxes won't compensate, in her view. Yager says an investor seeking tax relief would be better off heading to a diversified ETF.

Meanwhile, the new products are raising hackles in the mutual-fund industry. Last summer, the Investment Company Institute, the industry trade group, asked the Securities and Exchange Commission to take a closer look at the offerings, which aren't subject to the same scrutiny as mutual funds. And just last week, ICI President Matthew Fink told reporters that such products could be classified as "closet mutual funds."

Countering such complaints, Netfolio founder Jim O'Shaughnessy, himself a former mutual-fund manager, maintains that traditional funds "cost too much, are not customizable and are not tax friendly." With Fidelity and Schwab, a significant chunk of the industry has apparently decided that if it can't beat the create-a-funds, it might as well join them. But whether most individual investors should be weaving these baskets for themselves remains to be seen