In mutual funds, looks are critical.
Whenever a fund gets really hot, it has the right look -- big performance numbers to lure investors. The problem is that, in an uncertain economy and stock market, today's beauty queen could be shattering mirrors tomorrow.
Industry experts and financial advisers routinely warn against buying into funds that top the charts. Those funds, the warnings go, tend to take on more risk than their peers and can be subject to losses just as ugly as their gains are gorgeous.
But nothing discourages the performance cult, people who ignore those warnings and often fall into the category of "LIFOs" ("last-in, first-out.") Typical LIFOs not only arrive too late to get the sexy performance, they tend to bail out upon realizing they are stuck with an ugly stepsister.
Right now, however, performance surfers and LIFOs are laughing at the experts. For the time being, riding the charts has meant buying funds that have continued to perform, notably funds heavy in technology, particularly sector funds.
Ironically, returns are hindsight. That same field of vision shows that the bulk of money flows into funds much closer to the end of a rally than the beginning. In other words, judging from the cash flows, the experts could get the next laugh.
"It's human nature to bet on the favorites," says Robert Powell, editor of Mutual Fund Market News. "The problem is that people are buying things like Seligman (Communications & Technology Fund, the top performer over the last five and 10 years) when they should be out looking for the next Seligman."
That's tough to do, especially when current hot funds look so good. Nearly half of the top 25 funds thus far this year -- and a third of the five-year leaders -- are technology funds.
The result is a gusher of money for tech funds. But that money missed the early rally, showing up only as many experts have gotten nervous about technology issues.
Consider, for a moment, the cash flows into some of the largest tech funds. Ten years ago, for example, Seligman Communications & Technology was a $40 million fund. It had the best five- and 10-year record in the business at the end of last year, by which time it had grown to just more than $300 million. Then there is this year, when the fund has returned enough -- 70 percent -- to add another $200 million to those assets.
But, as of June 30, the fund's assets topped $1.6 billion.
That means that the fund -- which was closed to new investors several months ago -- is more than two-thirds new money. The investors behind that cash never got that top 10-year performance, nor the best five-year returns. Of the new money crowd, the lucky few are those who showed up in time to catch most of this year's run; sadly, most newcomers missed that boat.
"People chase recent numbers, and they forget the basics," says Michael Stolper, editor of the Mutual Fund Monthly newsletter. "There are a lot of funds with 20 and 25 percent gains this year that are in net redemptions because people don't think that return is enough. Those people will chase the hot numbers, but they usually won't catch that hot performance."
For proof and in prediction, Mr. Stolper notes that over the last 10 years, technology sector funds had a compounded annual return of 16 percent, just one point higher than the broader market, as measured by the Standard & Poor's 500. "The market has a way of evening things out over time," Mr. Stolper says. "I won't say technology stocks can't go higher, but the probabilities are against the people who buy in now. Last week, investors got a taste of what can happen during Monday's technology sell-off. Mutual funds specializing in technology stocks fell 3.9 percent.
To buy into a hot fund -- and especially a sector fund -- an investor should believe that the stocks being purchased are not overvalued. Investors who chase returns buy numbers alone, ignoring the underlying portfolio.
Most experts suggest middle-of-the-road investment strategies. For people considering the hot funds -- or already there -- here are a few suggestions for getting ahead:
* Take profits and rebalance the portfolio.
"There is something to be said for locking in good results, because no good run lasts forever," says G. Edward Noonan of Triad Mutual Fund Investors Corp. in Hingham, Mass. "If they got in as late as this year, they may have some nice profits. They might want to lock some of those [profits] in now."
L * Stick with a winning fund, even as returns get less gaudy.
Funds regress to the mean; nothing stays hot forever. But going from a tremendous year to a good one is no crime, especially when the fund is part of a portfolio that diversifies risk and meets investment goals.
Says Mr. Powell: "People who jump from hot fund to hot fund think they will get only the best returns. What they usually end up with is the worst, buying fund after fund on the way down and never settling for decent returns over time.
* Adjust your attitude.
LIFOs wait too long to buy, expect too much and are almost always disappointed in the end. They are, says Mr. Stolper, "incurable."
Heal yourself. Riding at the top of the market -- especially in nervous times like these is not for everyone. Beating the averages, over time, should be enough.