You're Holding the Bag on Financials

Big financial institutions have lost billions of dollars. And you're the one paying for it.

It's too early to tell just how big the taxpayer bill for the various bailouts, bank failures, and bankruptcies might be. It's not clear whether the proposed merger between Bank of America (NYSE: BAC  ) and Merrill Lynch (NYSE: MER  ) will prove to be the low-water point, or whether it will fall apart and be just one more story in a seemingly endless saga of misery. But one thing is for sure: Mutual fund shareholders have already taken a big hit.

Despite the many advantages large institutions have over small investors, several fund managers simply made the wrong bet on financial stocks. Unfortunately, many small investors have borne the brunt of their managers' mistakes, as their fund shares have dropped precipitously. Although it's too late to avoid the losses that have already happened, it's worth looking at what happened in the hope of preventing yourself from repeating that mistake.

All part of the index
Perhaps the most disturbing thing about the financial crisis is that so many investors had exposure to the stocks involved. Most of the large institutions that have seen major problems are current or former components of the S&P 500 index. A look at the annual report from the Vanguard 500 Index Fund shows exactly how much of the index, as of last Dec. 31, was made up of what proved to be disastrous stocks:

Stock

Holdings by Index Fund (in millions)

% Share of Index Assets

Fannie Mae (NYSE: FNM  )

$370.6

0.30%

Freddie Mac (NYSE: FRE  )

$213.5

0.18%

Bear Stearns

$96.8

0.08%

AIG (NYSE: AIG  )

$1,400

1.15%

Lehman Brothers (NYSE: LEH  )

$328.7

0.27%

Washington Mutual (NYSE: WM  )

$112.1

0.09%

Source: Vanguard Group.

For a fund that held almost $122 billion in assets at the end of 2007, the $2.5 billion that these stocks represented wasn't a huge amount. But even making up just 2% of the index, the contribution of these losing stocks certainly hasn't helped the S&P 500 any.

Taking a bigger hit
Unfortunately, some investors had more exposure to these toxic stocks, thanks to their fund managers. For instance, as recently as June 30, the Dodge & Cox Stock Fund (DODGX) owned more than 50 million shares of AIG and nearly 40 million shares of Fannie Mae -- which were then valued at over $2.1 billion, or about 4% of the fund's net assets. Meanwhile, the Legg Mason Value Trust (LMNVX) held around $550 million worth of shares of Freddie Mac and AIG on June 30 -- close to 6% of its total assets.

Your first reaction to this might be to think you'd like to keep a closer eye on what your fund managers are doing. However, because many funds only disclose holdings on a quarterly basis, you won't always get advance notice of a big increase in a position you don't like. For example, as recently as fall of last year, Legg Mason Value Trust didn't own a single share of Freddie Mac.

The fact is that you pay fund managers to take decisive action to make money. When your manager makes good picks, you can appreciate your fund's ability to buy substantial numbers of shares without disrupting the market. But when a manager fails, it's likely to be a spectacular failure -- and one that you don't necessarily have any control over.

What to do
What you do have control of, however, is how much money you turn over to other people to manage for you. During a bull market, any manager can make money. But during bear markets, value traps abound, and even the most experienced managers can fall prey to them.

If you doubt your fund manager's ability to invest during tough times, you should consider replacing that mutual fund with a similar index fund. With the vast number of index mutual funds and ETFs that track any number of specialized sectors and segments of the market, you should be able to find one that matches well against any actively managed mutual fund you happen to own.

Although investing in an index will guarantee at least some exposure to tomorrow's dud stocks, you don't have to worry about overzealous bottom-fishing fund managers biting off more than they can chew by doubling or tripling down on a position -- and putting your money at risk.

For more on the current financial crisis, read:

If you think your mutual funds aren't doing right by you, why not get a second opinion? Our Motley Fool Champion Funds newsletter helps guide you through the thousands of funds out there to find the best ones for your portfolio. Want to see for yourself? Try it out for 30 days free -- with no obligation.

Fool contributor Dan Caplinger held the bag for these folks in his index funds. He doesn't own shares of the stocks mentioned in this article. Bank of America is a Motley Fool Income Investor recommendation. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy tells it like it is.


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