June 7, 1998
By GRETCHEN MORGENSON
The bull market in stocks has been long and lovely, but even unsophisticated mutual fund investors understand the nature of market risk. If the prices of many stocks in a fund's portfolio drop, fund holders will lose, too. 

Understanding a fund's exposure to liquidity risk, however, is quite another matter. Liquidity risk is the possibility that the price of a stock will drop, and therefore may push down the fund's net asset value, when a manager tries to sell a large position. Or that the price will climb, forcing a manager to pay too much when buying a large chunk. 

Unless investors have examined a fund's holdings in each stock and compared them with the total shares outstanding in the company, it is tough to fathom such risk for a particular fund. 

Although it is not much of a concern in large-cap stock funds, liquidity risk can wreak real havoc in micro-cap funds, which invest in fledgling companies with market values of $250 million or less. Positions in such companies are much harder to get in and out of without roiling the market. 

How damaging can illiquid stocks be to a portfolio? Plenty, as shareholders in two Dreyfus small-cap stock funds, Premier Aggressive Growth A, with $264 million in assets, and Aggressive Growth, at $77 million, are finding out. 

Indeed, these two funds are textbook examples of the perils of illiquidity. So far this year, through Thursday, shareholders in Premier Aggressive Growth have lost 13.5 percent; those in Aggressive Growth are down 18 percent. As a benchmark, the Wilshire Small-Cap index is up 10.8 percent. Last year, Premier Aggressive Growth was down 13 percent; Aggressive Growth lost almost 16 percent. 

Aggressive, yes. Growth, no. 

Performance like this may explain the April news that the funds' manager since August 1995, Michael L. Schonberg, was being joined by Paul A. LaRocco, late of Founders Asset Management in Denver, who was named the primary manager. Mellon Bank Corp. owns both the Founders and Dreyfus fund companies. 

For the two and a half years that Schonberg ran the fund alone, he bought speculative technology or biotechnology companies with few shares outstanding. He even borrowed money to buy shares. 

LaRocco takes a different tack, favoring bigger-name stocks with $1 billion to $5 billion in market value. In an interview, he said he is still running the funds as aggressive-growth vehicles. "But we will broaden the funds' holdings out a little," he said. "Mid-cap stocks are a good place to be here. As earnings growth among large-cap stocks slows, investors will move down the market-cap range." 

Dreyfus did not make Schonberg available for an interview last week. 

Even if LaRocco is a brilliant stock-picker, the beleaguered Dreyfus fund holders are not likely to recoup their losses any time soon. That is because escaping a portfolio of illiquid stocks is like exiting a crowded theater after somebody has yelled "Fire!" 

How illiquid are some of the holdings? Frighteningly so. According to Morningstar Inc., the Chicago financial publisher, the median market capitalization of the larger of the two funds, Premier Aggressive Growth, is a Lilliputian $157 million. Across the micro-cap fund category, only 20 percent of funds have a median market capitalization this small or smaller. 

The median market cap of Aggressive Growth is even smaller, at $87 million. Only 10 percent of micro-cap funds in Morningstar's universe have median market values that tiny. 

More than 10 percent of Premier Aggressive Growth's assets are in stocks that trade at $5 a share or less. In the Aggressive Growth fund, 20 percent fall in that range. 

Another measure of both funds' high risk levels can be found in the concentration of fund holdings. As of April, Premier Aggressive Growth held 70 stocks; each of the top six holdings accounted for between 4 percent and 7 percent of the fund's assets. 

Aggressive Growth was even more concentrated, at 54 stocks. Its No. 1 holding, a cosmetics and medical technology concern called Chromatics Color Science International, accounted for almost 13 percent of the fund's assets. That's staggering, given that a top holding in a fund typically accounts for 2 percent to 3 percent of assets. 

Dreyfus is making a big bet on Chromatics Color Science, a company that was brought public in 1993 by Investors Associates, a brokerage firm that closed last year after a number of state securities regulators revoked its license. Chromatics Color Science trades around $11.50, down from $17.25 in March. Dreyfus owned 1.5 million shares as of March, more than 10 percent of the company's shares outstanding. 

The bet on Chromatics is not the only big gamble fund holders have made. Almost 30 percent of the assets in Premier Aggressive Growth are stocks of obscure companies in which Dreyfus owns more than 5 percent of the shares outstanding. In the Aggressive Growth fund, 67 percent of the assets are stocks of companies in which Dreyfus owns more than 5 percent of shares. 

For example, in March, Dreyfus owned 23 percent of Atlantic Pharmaceuticals, a development-stage biotechnology company trading at around $6.25 that has no sales and lost $14 million since 1994.. Dreyfus also owned 16.4 percent of Oncormed Inc., another money-losing biotechnology concern, trading at 75 cents a share. Then there's Advanced Photonix, which says it manufactures "proprietary solid-state large-area avalanche photodiodes." Some 14 percent of the stock, trading at a recent $1, was owned by Dreyfus as of March. 

This concentration in illiquid stocks is fine when the fund manager is buying. As the buying wave rises, so does the stock's price. This in turn raises the fund's net asset value, making the bet look smart. 

But when the buying dries up, trouble begins. If the stock does not have positive earnings or other good news to support it, the price begins to flag. The bigger the position, the harder it is to get out. Which is precisely the predicament that LaRocco finds himself in at Dreyfus. 

Jon Hale, an equity fund analyst at Morningstar who follows Dreyfus funds, said: "This portfolio is not something you can change that quickly. He will rotate as he can out of most of the micro-cap stuff as the market lets him." 

LaRocco has two choices. He can unload the positions he inherited en masse and start fresh. Or he can hope that a surge in investor ardor for micro-cap stocks will allow him to sell his positions piecemeal without scorching the market. He has already started to sell some. This may explain why Premier Aggressive Growth is down 13 percent since early April, when LaRocco took over, and Aggressive Growth has lost 15 percent. "The sooner these funds have restructured their portfolios," Hale said, "the better their risk-return profile will be." 

Of course, if the funds sell many stocks at a loss, any gains going forward under their new manager may be offset. That is the only silver lining to the liquidity cloud hanging over these mutual funds.