(MONEY Magazine) – This summer's market carnage carries two lessons for fund investors: Stocks don't always go up, and mutual funds aren't always very "mutual." You've probably learned the first lesson the hard way, after seeing the alarming quarterly losses on your September account statements. But the second lesson is important too. In fact, the term "mutual fund" has always struck me as an oxymoron, one of those impossibly contradictory phrases like jumbo shrimp, airline food or United Nations. If your funds were really mutual, they'd cut their fees instead of raising them; they'd stop taking in money before they bloated beyond recognition; they wouldn't bombard you with unnecessary tax bills; they wouldn't shuffle managers faster than the Florida Marlins shuffle players. Unfortunately, that's just the way many funds are run--not very "mutually" at all.

Mark Liebman learned both lessons this summer. Liebman, 57, is a cantankerous retired writer living in New York City and a self-described "fund junkie." Not only did his fund portfolio (which he holds at discount broker Charles Schwab) lose 7% of its value in the third quarter, but his funds have begun mutating into alien entities. And Liebman is hopping mad. "Instead of just fighting the market," he says, "I've come to realize I now have to fight my fund companies as well. These people are antithetical to my interests."

What's got Liebman's knickers in a twist? Last year the Acorn Fund raised its fees by 53%--and Liebman sold his shares in disgust. Now, just in the past few months, three of his funds have merged with others: Heartland Small Cap Contrarian is being absorbed into Heartland Value; Robertson Stephens Partners has digested its sibling, Global Low-Priced Stock; and Strong Growth is taking over Strong Small Cap. The funds he'll end up owning, Liebman feels, are not what he wanted when he bought them. And if he sells them in protest, he'll get hit with a big tax bill.

Why should you care? Because Liebman's headaches may soon be yours. According to Lipper Analytical Services, there were 257 fund mergers in the first seven months of 1998--up from just 131 in the same period last year. And that's just the tip of the iceberg. More than 3,600 stock or bond funds have been created in the past decade, and hundreds of them are too sickly or too small to survive. So I expect a wave of mutual fund mercy killings over the next few years.

By merging a dying fund into a bigger one with a better record, the management company gets to keep earning fees on the combined assets--and, not coincidentally, to bury the rancid record of the dead fund. That, in turn, enables the firm to report an overall track record that appears better in retrospect than it was in reality. Thus from the fund company's perspective, playing Dr. Kevorkian makes sense. But it doesn't necessarily work for shareholders.

Mark Liebman invested in Heartland Small Cap Contrarian when it opened in early 1995. He bought it, explains Liebman, "because I thought Heartland Value [then at roughly $700 million] was already overstuffed. That fund had all its glory years when it was under $200 million." But now, after Heartland Value takes over Small Cap Contrarian, it will hold a whopping $1.7 billion in assets.

Of course, Liebman doesn't have to stick around. He could sell this fund and buy a smaller one. But then, having already lost 24% in Heartland Small Cap Contrarian this year, he would suffer the double indignity of having to fork over capital- gains taxes on the roughly 2% annual return he's earned since 1995.

Not surprisingly, Bill Nasgovitz, who runs Heartland Value, argues that shareholders like Liebman will be well served if they stay: "We've outperformed the Russell 2000 [small-stock index] every year of the 1990s, in good markets and in bad, when the fund was large and when it was small." Liebman, however, is not encouraged--especially since Heartland Value, which Liebman thought was bloated a billion dollars ago and has been closed to new investors since 1995, is reopening this month.

Liebman bought Robertson Stephens Partners in late 1996. "The fund was up 43% that year with more than 40% in cash," he recalls, "so I figured it would be a good bear market fund." Not this year, anyway: Partners has lost 25% of its value. In July, Partners--at $102 million in assets--absorbed its $4.6 million sibling, Global Low-Priced Stock, which had lost more than 21% over the previous year. Partners manager Andy Pilara says the merger had "no real investment relevance," because nearly all the stocks in the two funds were already held in common. "I don't want to own even more of the same lousy stocks," protests Liebman. "Why don't they just fire the manager?"

"I look like a goat in 1998," responds Pilara, "but I looked like a hero in 1996. With any portfolio manager, you can pick out one or two years of poor performance, but that's much too short a time frame to make a judgment."

Liebman invested in Strong Growth in mid-1994, when the six-month-old fund had just $50 million in assets. Now it's got $1.5 billion and is about to swallow $80 million Strong Small Cap (which has lost 11% this year). After crushing Standard & Poor's 500-stock index by more than 10 points a year in 1994 and 1995, Strong Growth's manager Ron Ognar has lagged the market ever since. "They've already blown that fund up until it can't move anymore," says Liebman. "What's the point of making it even bigger?"

Ognar says his fund has always been able to buy little stocks and is considering putting as much as 60% of its assets in small-caps anyway. So he thinks Strong Small Cap's $80 million in assets will fit nicely. "I think shareholders will be glad they went along with the merger," says Ognar. "There's a trade-off now that we're a $1.5 billion fund: We can't take the tack of buying very small companies, but we can give more stability and less volatility in returns."

Size is not the only issue here. When a fund loses money, it can at least turn those losses into a tax advantage: A portion of realized losses can be used to offset up to eight years of future realized gains, which can save shareholders millions if performance improves. But when a fund is merged, most of those tax benefits become unusable.

As of June 30, Strong Small Cap had roughly 90[cents] per share in tax losses. If the fund had stayed intact, much of those losses could have been used to offset future gains. Instead, with the merger into Strong Growth, that valuable asset is diluted almost into oblivion, divided among all the shareholders of the much bigger fund. For some reason, fund companies seem to feel they have the right to deprive their shareholders of this hard-earned asset.

The travails of Mark Liebman, who is one of the most knowledgeable fund investors I've met, trouble me for another reason: While it's natural for fund managers to put the best face on their decisions, there is a group of people who are supposed to ensure that funds are run in the exclusive interest of shareholders: the "independent" members of the board of directors. At most fund companies, some three to five outside directors earn anywhere from $5,000 to $300,000 to meet up to a dozen times a year and serve as watchdogs over the people who run the family's funds. When a fund's performance withers and its assets shrivel, the directors have the authority to take action, and they have many options besides merging the fund with one of its siblings. The directors could urge the fund company to hire a better portfolio manager; they could liquidate the fund and send shareholders a check for the proceeds (as Robertson Stephens is about to do with its Developing Countries fund); or they could find an outside firm to run the fund.

After all, a new portfolio manager may well be better than the old one. And if you bought a small-stock fund, you probably wanted to own small stocks. Finally, as we've seen, keeping a fund alive may be the only way to preserve your potential tax benefits.

Over the years, I've found that nothing irks fund directors more than the suggestion that they act as "rubber stamps" for the decisions of the fund management company. But did the independent directors of the Strong funds consider hiring an outside manager to keep Strong Small Cap alive? "That was not an issue that ever came up," says Stanley Kritzik, one of Strong's independent directors, "and I have to admit it never occurred to me."

Nor at Heartland, Bill Nasgovitz concedes, did the fund's board consider seeking an outside firm to run Heartland Small Cap Contrarian (even though that would have salvaged some tax benefits for its shareholders).

No wonder Mark Liebman feels that the directors of his merging funds let him down. "I don't know who the boards of directors work for, but I know it's not me," he says. "The shareholders are not foremost in their minds by any stretch of the imagination."