High-performing equity funds offer risk along with the potential for profit


"I want to invest in your health-care fund," the caller tol Vanguard's service representative, "but I don't want to take any chances with my principal."

He was obviously struck by the performance of Vanguard's Health Care Portfolio: a total return of around 35 percent since the stock market's turning point in mid-October -- not bad, if not as high as the average total return of around 50 percent calculated by Lipper Analytical Services for the group of health and biotechnology funds that it monitors.

Similar phone calls have been coming in to Vanguard and other (( fund families from new investors who had heard about the recent gains of science-technology and small-company growth funds. Lipper reported average returns of around 50 percent and 40 percent, respectively, for these groups during the same period.

While some high-performing equity funds of the recent past may continue to be profitable investments, looking only at past performance --and forgetting the risks associated with a particular fund -- can be costly.

The person calling Vanguard was clearly mindful of the risk of losing money, but assumed wrongly that it did not apply to this equity fund. Since you, too, may have been attracted by an equity fund reporting a high double-digit return for only a few months, you'll want to remember that you are taking chances with your principal whenever you invest in one.

No matter how well a fund is managed, you cannot escape the risk that its shares' prices could be below your cost -- especially ,, in the first few years that you hold them -- if you have to sell.

Thus, you'd only want to go into an equity fund if you can plan to be in it long enough to ride out short-term fluctuations, and if you can reasonably expect its return to exceed what you can earn from other investments.

When prospecting for an equity fund, you want to aim at finding one that is likely to earn your desired rate of return without exposing you to excessive risk.

If you're looking for a fund that could generate a high return, you have to be able to tolerate the higher risk it's probably going to involve. If you can tolerate only low risk, you'll probably have to be content with a lower rate of return.

To select an equity fund suitable for you among the more than 1,000 in operation, you'll find it helpful to begin by relying on the system that the fund industry and data services have developed for classifying them according to investment objectives and strategies.

At first glance, the system may be confusing. Some fund families assign all of their equity funds to three or four categories. The SEC uses six classifications. The Investment Company Institute, which employs eight categories, has further grouped many of the funds in 13 "specialty fund" lists in the new edition of its annual "Directory of Mutual Funds."

Lipper divides equity funds into as many as 19 groups, as you'll see when first-quarter performance data appear. Others follow still different practices.

To take advantage of this array of categories -- and avoid being confused by inconsistencies -- remember some basics.

There are essentially only three investment objectives that you can pursue by investing in equity funds: growth, income or a combination of the two.

Differences among funds, which lead to the creation of all these categories, arise from the differences in policies and strategies pursued to achieve growth, income or both.

Naturally, you'd want to look at growth funds if you are primarily interested in long-term growth, and at growth and income funds if you want a moderate amount of income along with growth. Growth and income funds are generally less risky because their greater dividend income tends to moderate their volatility.

Funds in most other equity categories seek higher growth and could involve more risk. Among broad groupings, aggressive growth funds (called capital appreciation funds by Lipper) often realize short-term gains with a resulting high portfolio turnover; they also engage in other speculative practices.

Small-company growth funds tend to be more volatile because the stocks of small companies tend to be more volatile than those of large corporations favored by growth funds. International funds, investing in stocks of foreign companies, involve currency exchange risks in addition to the usual risks.

Beyond these diversified categories, most consist of funds concentrated in single industries, such as health care and science-technology. When the industries are prospering, the funds do better than the broad market.

But when the industries are having problems, the funds lag.

Eventually, you have to go beyond labels. When you have found a category that looks promising, obtain the prospectuses and reports of its leading funds to see whose investment goal comes closest to yours, whose performance record has been most consistent, and which is most forthright in describing the risks you'd incur by investing in it.

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