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Originally published Saturday, April 7, 2012 at 8:02 PM

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Chuck Jaffe: How an Apple in the window eases fund shareholders' worries

The recent announcement that Apple will start paying a dividend gives investors insight into how some funds use hot stocks to game the system, beat the ratings/rankings game and fool investors.

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One reason investors buy mutual funds is to get exposure to the big names and hot stocks.

For the past three years, one of the biggest, hottest names has been Apple, which turned a $10,000 investment at the start of 2009 into more than $60,000 today.

Not surprisingly, the stock is a mutual-fund staple, accounting for more than 5.5 percent of the average large-cap portfolio, according to Morningstar.

But the recent announcement that Apple (AAPL) will start paying a dividend gives investors insight into how some funds use hot stocks to game the system, beat the ratings/rankings game and fool investors.

This has nothing specific to do with Apple, and everything to do with how managers run funds; to see that clearly, start with the tech giant's recent announcement that it will pay a quarterly dividend of $2.65 per share beginning in July.

For income investors, that yield of less than 0.5 percent only makes the stock marginally attractive.

But if you believe that Apple will keep on growing, the fact that Apple now qualifies as a "dividend-paying stock" is huge.

It means that equity-income managers can buy a fast-growth stock that heretofore hasn't belonged in a fund with income/dividends as a significant part of its mission.

Here's where things get interesting; plenty of dividend-driven fund managers already own Apple.

Based on portfolio data that is was months old when Apple made its announcement, at least 10 percent of funds with a mandate for dividends/income actually owned Apple before the announcement was made.

Hmmm.

Now, the prospectuses for some of these funds leave plenty of leeway for the managers to go where they want, often with some specific income goal — like a yield that beats the Standard & Poor's 500 index — as a target to shoot for.

With the S&P currently yielding about 1.75 percent, however, Apple hasn't been helping to exceed the benchmark yield, and won't be a giant boost even when its cash payout starts.

While every equity-income manager could give some reason for having purchased Apple before it ever announced a dividend, you can file this move under "window-dressing," which is a way managers can gussy up a portfolio to appease investors.

Window-dressing typically occurs just before the record date for a fund to publish its holdings.

A manager whose performance is lagging jettisons issues that look bad in exchange for issues that shareholders recognize and covet, hoping that when shareholders examine the holdings they'll see a portfolio that looks better than the results it has delivered, creating hope for the future.

While managers have always decried window-dressing is an urban legend — swearing they would never diverge from their strategy just for appearances sake — reality says otherwise, both in certain trading patterns that experts say show up at the appropriate times of the year, but also in cases like this one.

If not window-dressing, at the very least it is a manager looking for a way to game the system.

If the traditional equity-income stock is a slow-growth company and a manager forsakes the dividend mandate to get a fast-growth star like Apple, it can improve total returns to where the fund looks better than competition that stayed entirely within the boundaries of the category.

It's easy to get away with.

If the prospectus doesn't prohibit it — and most don't — the rules governing funds named for a specific asset class — such as technology or equity-income — say that only three-quarters of the fund has to be in those kinds of issues.

As a result, it's easy to find examples beyond Apple.

There are more than two dozen small- and mid-cap funds that hold Berkshire Hathaway A shares (BRK.A), for example, and they didn't all buy the stock when it was trading at $1,000 per share and ride it up to $122,000.

The stock hasn't qualified as a small- or mid-cap stock since before Warren Buffett was a billionaire, but he's such an icon that the company's presence in a portfolio comforts investors.

No one complains when the strategy works.

After all, it's hard to criticize a manager for not doing his or her job when performance is at or above peer levels, even if those results haven't been achieved entirely by following the fund's mandate.

With that in mind, growth-and-income investors shouldn't be upset if they look at their fund's holdings and find Apple already in there; they should simply recognize that their fund manager is playing at the edge of the rules.

That's great when it works, but a shocker when it doesn't.

It's precisely why so many investors were gobsmacked when the market cratered in 2008; if you don't recognize the liberties a manager takes to turbocharge returns, you can't see what might fuel the next potential burnout.

Ultimately, it's why investors should examine a fund's holdings, not just with an eye toward what's in there, but whether it really belongs there.

Seeing names that are comforting is only a positive if those securities also fit in with the fund's mission.

Chuck Jaffe is senior columnist

for MarketWatch.

He can be reached

at cjaffe@marketwatch.com

or at P.O. Box 70,

Cohasset, MA 02025-0070.

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