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Problems of Cornerstone Funds Persist


The Cornerstone Funds group in New York was looking forward to starting the year off with a trio of newly-hired service providers. The goal was to slash costs.

Despite these efforts, though, the fund group, which was formerly known as the Fundamental Funds, has found itself fighting some familiar demons once again. Poor performance coupled with falling assets and high costs have cast a shadow over the fund family.

The funds, advised by Cornerstone Equity Advisors, have hired Tripp & Co. as the group's new distributor, replacing the former distributor, Cresvale International (US.) of Hong Kong, according to a Dec. 23, 1999 amendment to the fund group's prospectus.

The fund group's board also voted to appoint Deloitte & Touche as the funds' new independent accountant, replacing PricewaterhouseCoopers, according to the filing. In 1999 PricewaterhouseCoopers acquired the mutual fund audit division of McGladrey & Pullen. McGladrey had served as the fund's original independent accountant.

Cornerstone Funds group has also hired the law firm of Willkie Farr & Gallagher of New York to replace Kramer, Levin, Naftalis & Frankel, also of New York, which had previously represented the fund.

Cornerstone switched service providers in order to reduce its costs, according to a company spokesperson. The president of Cornerstone, Stephen Leslie, did not return a call seeking additional comment.

Expenses are a major concern for Cornerstone. High expenses have plagued the fund group for several years. Even when the five funds were known as the Fundamental Funds and were managed by the group's original adviser, Fundamental Portfolio Advisors of New York, fund expenses were high.

According to data supplied by Lipper of Summit, N.J., two of the five funds, the Cornerstone U.S. Government Strategic Income Fund and the Cornerstone High-Yield Municipal Bond Fund, are both currently saddled with expense ratios of more than three percent.

That is actually a vast improvement for the Cornerstone U.S. Government Fund that, during 1998, had an expense ratio of 5.1 percent. In 1999, the average U.S. Government bond fund had an expense ratio of close to 1.0 percent, according to Morningstar, the fund tracking company in Chicago.

Also in 1998, the Cornerstone High Yield Municipal Bond Fund had expenses of a sizeable 4.2 percent. The average expense ratio for high-yield funds during 1999 was 1.3 percent, according to Morningstar.

Three of Cornerstone's five funds ranked as the worst performing municipal bond funds in all of 1999, according to Morningstar. For the year ended Dec. 31, 1999, the $11 million Cornerstone California Muni Fund returned -29.4 percent; the $63 million Cornerstone New York Muni Fund returned -18.3 percent; and the Cornerstone High Yield Municipal Bond Fund returned -12.6 percent.

Both the Cornerstone California Muni and New York Muni Funds have also been the worst performing funds over the past 3-, 5-, and 10-year periods, according to Morningstar. Fund assets have dropped from a combined $180 million in February 1998 to the current $78.5 million.

Part of the funds' problems are their interest rate sensitive portfolios, said Eric Jacobson, an analyst with Morningstar. That interest rate sensitivity showed through in 1999 when interest rates were raised on multiple occasions, he said.

The Cornerstone California Muni Fund, for example, is "loaded with inverse floaters," Jacobson said. Experience has shown that sophisticated derivatives such as inverse floaters can be troublesome unless fund managers are very savvy, he said.

"Some more sophisticated funds may put in inverse floaters," said Jacobson. "But big companies are better able to evaluate the interest rate sensitivity."

In addition, the Cornerstone California Muni Fund was reporting a 13-year portfolio duration that is quite long, Jacobson said. Duration is a measure of the potential sensitivity of a fund to interest rate changes. The longer the duration, the more sensitive it is to interest rate increases. Interest rate sensitivity is compounded if a fund is leveraged, said Jacobson.

Ironically, the Cornerstone Funds are running into obstacles similar to those faced by its predecessor Fundamental Funds. In September 1997, the SEC explored both interest rate sensitivity issues surrounding the use of derivatives and the funds' duration. When interest rates spiked in 1994, the funds showed significant losses.

At that time, the SEC brought an administrative action against the Fundamental U.S. Government Strategic Income Fund (now the Cornerstone Strategic Income Fund). Two of its executives were charged with misrepresenting the riskiness of the fund in marketing documents. The SEC also alleged that the fund executives had knowingly miscalculated and misrepresented the true duration of the fund to shareholders and potential investors. The NASD also sanctioned the fund with a record monetary penalty for the same actions.

Consequently, the Fundamental Funds' board of directors fired the fund's original adviser and chose Tocqueville Asset Management of New York as the fund group's new adviser. But after months of negotiations, Tocqueville and the funds' board members failed to agree on the strategy of the funds and the two severed ties.

In September 1998, the fund board hired Cornerstone, a newcomer to the mutual fund investment business, to manage the five funds' investments. The fund names were subsequently changed to reflect the new adviser.