Saturday, September 8, 2001

Bank of Hawaii Senior Vice President Dave Zerfoss,
front left, who oversees Asset Management Group's
investment department, is joined by VP Lorene
Okimoto, Senior VP Bill Barton, front right, and
VP Scott Takemoto in a bank work area.

Bankoh preps funds
for market turn

The head of investments sees
more rate cuts coming but
believes stocks are poised to rally

By Dave Segal

If it looks like a recession and feels like a recession, then it must be a recession.

Technically, of course, it's not. Gross domestic product eked out an annualized 0.2 percent growth in the second quarter. But that's little comfort to the owners of individual stocks and mutual funds who have seen their wealth deteriorate over the past 18 months.

"It's like taking a long night's sleep after a long physical day," said Bank of Hawaii Senior Vice President Dave Zerfoss, who oversees the investment department for the bank's Asset Management Group. "I've been in this business 33 years and I've been there before. I try to put it into context to people who haven't been there before and they seem to be comfortable with it.

"Normally, it's two steps forward and one step back. Then in the '90s it was 10 steps forward. Now it's been four steps back in a row. For people who came into the market late in the game, it's been tough. For people who bought early, they've averaged 12 or 13 percent over the past five years even after the big decline we've seen in the last year. A vast amount of the pain already has been suffered. Now is not the time to bail out."

Bank of Hawaii, which manages 16 mutual funds with total assets of $4.1 billion, is well positioned to ride out the volatility due to its broad spectrum of offerings. It manages 12 funds in the Pacific Capital Funds family. They include three taxable bond funds, two tax-free bond funds, six equity funds and one balanced fund. Bank of Hawaii also offers one tax-free fund as well as three money-market funds under the Aquila Group of Funds family. Thirteen of the bank's 16 funds are managed locally, with the New Asia Growth Fund, International Stock Fund and Small Cap Fund managed by subadvisers outside the state.

"Most of our clients come to us for total investment solutions," Zerfoss said. "They're not looking to buy a particular fund in a hot area. They come to us for investment and use our mutual fund family, which has an offering in almost every category to satisfy their overall investment objective. That doesn't mean we wouldn't welcome people coming to us and saying they want this type of fund or that type of fund because we do have $200 million in public ownership."

Pacific Capital Funds' performances reflect the trend in a tough market, which has favored small-cap funds, value funds and fixed-income funds. Not surprisingly, its bond funds have shown positive returns.

The Diversified Fixed Income Fund, with $244.2 million in assets for all classes, is up 6.05 percent this year and 12.02 percent over 52 weeks. In order of descending year-to-date performance, it is followed by the Short Intermediate U.S. Treasury Securities Fund ($48.5 million), up 5.22 percent and 9.94 percent; Tax-Free Securities Fund ($487.1 million), up 5.22 percent and 9.07 percent; Tax-Free Short Intermediate Securities Fund ($43.0 million), up 4.46 percent and 6.71 percent; and Ultra Short Government Fund ($263.7 million), up 4.30 percent and 7.10 percent.

Among equity funds, the Small Cap Fund ($57.2 million) is up 16.26 percent and 26.25 percent; followed by New Asia Growth Fund ($21.2 million), down 8.21 percent and 29.42 percent; the Value Fund (223.5 million), down 9.37 percent and 13.85 percent; the Growth and Income Fund ($169.7 million), down 24.56 percent and 35.77 percent; the International Stock Fund ($79.2 million), down 26.62 percent and 36.05 percent; and the Growth Stock Fund ($340.6 million), down 31.08 percent and 42.06 percent. The Balanced Fund ($173.1 million), which invests in both equities and bonds, is down 13.08 percent year-to-date and 19.99 percent over the past 52 weeks. All of the results are through Thursday as calculated by Denver-based Lipper Analytical Services.

Bank of Hawaii also manages four portfolios under the Aquila Group of Funds. The Hawaiian Tax-Free Trust, which is the only Bank of Hawaii fund with a four-star rating from Chicago-based research firm Morningstar, is up 5.42 percent year-to-date and 8.87 percent over the past 12 months. The other three funds are money-market funds. The tax-free money-market fund offered a seven-day yield of 1.82 percent through Thursday while the government/corporate money-market fund offered a yield of 2.83 percent and the U.S. government money-market fund a yield of 3.01 percent. All three money-market yields listed are for retail shares.

Over the past two years, the Small Cap Fund has been the standout of all the funds with an annualized average return of 19.28 percent that ranks it in the top 20 percent of its peer group. The winner over the past three years has been the New Asia Growth Fund, which is a non-Japan fund, with an average annualized yield of 15.45 percent that ranks it in the top 33 percent of its peer group.

For five years, the Growth Fund has an average annualized return of 12.62 percent, putting it in the top 19 percent of funds in its category, while the Growth and Income Fund is close behind with a return of 11.29 percent that ranks it in the top 39 percent.

In all cases, the returns are for front-loaded Class A shares and include the expense ratio but not the sales charge.

Bank of Hawaii, which has 31 people in the investment portion of its Asset Management Group and additional support personnel, manages its funds through a team concept with a primary team leader.

"I think we have a wealth and depth of experience in our staff that would be bigger and deeper than anyone else in our business in the state of Hawaii," Zerfoss said. "Combined, we have eight chartered financial analysts and, to my knowledge, there are only three or four other CFAs in the state that are actively involved in the business. Our average portfolio managers have an average tenure of over 11 years and that's much longer than the average portfolio. People get burned out in this business. It's a tough business."

It's even tougher when the economy is struggling like it has been on the mainland. But Hawaii residents don't need to be reminded of that. The state is just emerging from a downturn that endured throughout most of the '90s.

"My guess is the mainland recovery is imminent," Zerfoss said. "I believe the recovery in the economy will probably occur in the current quarter. And if not in the current quarter, then early in the fourth quarter. We're already seeing some early warning signs. I feel the mainland economy has clearly seen the worst and conditions will start to improve fairly soon. Probably in the fourth quarter we'll see a definite upturn in corporate earnings. The stock market always perceives that, and because it predicts an economic upturn with an upturn of its own, then chances are a stock market rally is pretty imminent."

Zerfoss adds that Hawaii has weathered the slowdown quite well.

"In Hawaii, with tourism being the large driver, this is the second-best year we've ever had, and last year was the best," he said. "There hasn't been any market falloff as much as I can tell. Things could always be better, but we're in a lot better shape than other places, particularly our friends in Japan, who continue to suffer considerably. It remains to be seen, though, whether we continue to maintain the tourism level from the eastbound tourists given how bad their economy is, and the length of the mainland slowdown may hinder westbound traffic."

Despite the Federal Reserve already having cut interest rates seven times this year to avert a recession, Zerfoss believes there's still room to make money on bonds as well as in the beaten-up stock market.

"It's usual, although not always, that in the initial stages of a stock rally that the bond market does well," he said. "(A rally) is not mutually exclusive (to either bonds or equities). If you examine the recovery phases of markets in the aftermath of a recession -- even though we don't have a textbook recession, it feels like it -- there's ample room for bond prices to decline (thus pushing up yields) as well as for stock prices to go up. In baseball parlance, the bond market is in about the seventh inning and the stock market is about to hear the national anthem."

Zerfoss said in Pacific Capital's longer-term bond funds the holdings are longer than the benchmark average because of the belief that interest rates will continue to decline.

"We've already had a long decline (in yields) and (bond) prices have gone up immeasurably and I don't think that's over," he said. "With the Federal Reserve (expected to be) cutting again (on Oct. 2) and with inflation being quite modest, there is more room for rates to decline further. And when that happens, we'd be looking to shorten maturities and put our defensive team on the field and take our offense out. Stocks are the flip side of this but are about to turn."

Pacific Capital's most popular fixed-income fund, in terms of the most assets, is the Tax-Free Securities Fund because it invests in state of Hawaii debt and thus offers a double exemption that covers federal and state taxes.

"Our tax-free funds are about 55 percent to 60 percent invested in Hawaii and the rest is in mainland credit for diversification purposes," Zerfoss said. "There's a lot of demand for tax-free bonds in Hawaii because so many people are in a high income bracket. But Hawaii has the fewest number of municipal bond issuers in the country with a couple exceptions. Because of that, yields tend to be relatively low. Other states pay higher rates."

Among equity investments, Zerfoss's favorite sectors include financials, such as banks, savings and loans and insurance companies, because they all benefit from lower interest rates. He also likes health care stocks because of aging baby boomers, adding the caveat that the federal government is studying several proposals that could curb the profits of health-related companies. The fund family's holdings currently are market weighted in technology.

"There's been a lot of carnage," he said. "There's no doubt the pendulum swung too far, which is always what happens when it swings back the other way. I think it's normal.

"The biggest problem with tech stocks at the moment is a fundamental problem. If you look at the technology phenomenon of the late '90s, much of it was because of the capital goods frenzy for technology fueled by the fear of Y2K for several years. Companies were taking the point of view that they didn't know how Y2K would pan out and it would be better to buy a bunch of stuff for Y2K and update their stuff while they were at it. There was a compression of buying tech goods of all stripes that ended on Jan. 1, 2000.

"The tech picture continued on from an earnings and revenue point of view for several more quarters but then abruptly ended as sales started to slow down. Inventories got built up pretty rapidly and people didn't need all the tech equipment they ordered. There was more capacity than the world needed by midyear 2000.

"Worldwide, there's still a big amount of technology to be built and put into place. The technology phenomenon isn't over, but like every phenomenon that turns into a bubble, like gold of 1980, oil in 1978-80, the Nifty Fifty in 1973-74 and the Japan stock market in late 1989 to 1990, in almost every case the bubble takes awhile to re-establish itself. There's still a lot of good companies in tech and those companies will do quite well, but I don't think it's two or three years before the Nasdaq hits 5,000 again. I think it's eight to 10 years, which is still not bad as far as average returns. If it reaches 5,000 by 2010, that's 21/2 times where the Nasdaq is now, which is still a fancy return."

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