Managers are spending too much time chasing new stocks and not enough on analysing the facts
Savvy as modern mutual-fund investors may have grown, they'-re as bad as ever at the sector-fund selection game.
The sad evidence is plain to see in any current fund performance chart. Look at how these stock funds, which concentrate on sectors of the market such as electronic technology, financial and utility stocks, performed in the first seven months of 2001.
By far the biggest of seven sector categories tracked by the Chicago research firm Morningstar is technology, with 339 funds comprising $82bn in assets at last report. It's also the worst performer this year, with a 33% loss through 31 July.
The smallest category is precious metals, with 34 funds holding a vestigial $1.5bn in assets. Wouldn't you know, it's also the best performer, with a 7.5% gain. Healthcare, the second largest category by assets, with $43bn, has lost 15% year-to-date.
Utility funds, with $25bn, have declined 12%. The second smallest specialty, the $6.3bn natural resources category, has posted a relatively modest 8.1% loss.
Fund analyst Sheldon Jacobs has been documenting similar patterns almost since Fidelity Investments, sponsor of the biggest line of sector funds, started its first Select Fund 20 years ago.
'Surprisingly few sector fund investors actually pocket large gains,'' Jacobs writes in his Guide To Successful No-Load Investing. For example, tracing the history of the Fidelity Select Biotechnology Fund from 1986 through 1994, he found the fund's assets started out tiny, and remained less than $250m even as it rolled up investment gains of 44% in both 1989 and 1990.
Then, as the fund soared 99% in 1991, money poured in, swelling the assets to $1.1bn. Once all the newcomers climbed on board, the fund proceeded to average a 9.9% annual loss over the next three years.
It's almost as though these funds start out buoyant with few assets to carry, then sink after the weight of money builds up.
Only when the burden lightens are they able to rise again. We don't want to carry this image too far. If there's going to be a hybrid science of econophysics, I'm content to let someone more qualified blaze the trail.
Even so, experience and research show that popularity in sector funds, as in individual stocks, often correlates with disappointing performance in the ensuing months or even years. This is not illogical.
The price of any security naturally tends to peak when enthusiasm for it is strongest, and to reach a bottom when its last admirer gives up in disgust. 'Sector funds perform much more like individual stocks than do their conventional cousins, diversified mutual funds,' says Jacobs.
Have there been any good sector funds? You bet. The Vanguard Health Care Fund has averaged a 22% annual gain for the past 15 years, turning every $1 entrusted to it at the outset into a $20 bill at the end of 2000. The Fidelity Select Electronics Fund has averaged a 30% annual return for the past 10 years, even after the 2000-01 technology wreck.
The Invesco Leisure Fund averaged a 19% annual gain over the same stretch, beating the Standard & Poor's Composite Index by more than three percentage points a year.
There have also been the stinkers. Fidelity Select Environmental has averaged a puny 2.7% annual gain since mid-1991. Each $1 you put in Vanguard Gold & Precious Metals 10 years ago would have earned you a nickel by now.
The problem is figuring out ahead of time which ones are going to prosper. To do that successfully, you must possess some insight or instinct for the future that the majority of investors keep proving they don't possess.
It may be some comfort to know that fund companies also have trouble picking market sectors.
Most of the time, a recent Morningstar study discovered, the investment style or sector where new fund offerings are concentrated in any given year performs relatively poorly over the next three years. Better three-year results usually can be found in sectors with the fewest new funds.
The message here, says Dan Cullotonm an analyst at Morningstar, is that: 'Fund companies chase performance, and their timing isn't any better than anybody else's.''
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