Mutual Fund Monday

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New Real Estate Funds Crash and Burn

Lawrence Carrel

It may be the end of 2007, but mutual funds have been partying like it's 1999.

Let's hope investors don't experience a hangover like the one from 2000 to 2002.

As with the onslaught of new technology funds just before the Internet bubble popped, the industry has rolled out a slew of funds that invest in real estate investments at the worst possible time.

Forty real estate funds debuted this year, nearly double the 22 that were launched in 2006. These numbers include both domestic and global mutual funds as well as exchange-traded funds.

The timing couldn't have been worse. As last week's release of the S&P/Case-Shiller Home Price Indices illustrates, the housing rally is over. According to this leading measure of U.S. home prices, October was the 10th consecutive month of negative annual returns in the prices of existing single-family homes, and the 23rd consecutive month of decelerating returns.

The 10-City Composite Index's annual decline of 6.7% was a record low. The previous record was 6.3% tumble in April 1991. In October, the 20-City Composite recorded an annual decline of 6.1%.

No surprise, real estate is the worst-performing Morningstar fund category for the year to date, down 12.9% through Nov. 30.

The number of REIT funds that were rolled out this year isn't as high as the 113 tech funds that debuted in 2000, the year the tech bubble burst, according to Lipper.

But it's fair to say the fund industry didn't learn its lesson.

The list of fund families rolling out new REIT offerings last year includes household names such as Schwab, a unit of Charles Schwab (SCHW Quote - Cramer on SCHW - Stock Picks), Neuberger Berman, a unit of Lehman Brothers (LEH Quote - Cramer on LEH - Stock Picks) and Phoenix Funds, a unit of Phoenix Companies(PNX Quote - Cramer on PNX - Stock Picks).

Janus Capitol (GEF Quote - Cramer on GEF - Stock Picks) JNS, a firm known for investing in fast-growing companies that saw several funds implode along with tech bubble, also launched a REIT fund this year.

All the more shocking is that many of the REIT funds debuted this year after it was clear the housing market was in a decline.

Home sales began slowing as far back as 2005. By January 2006, housing prices peaked. With mortgage defaults and foreclosures surging this year, home prices have been falling ever since.

Considering the tech bubble's massive loss of wealth happened just seven years ago, you'd think mutual fund companies -- and investors -- wouldn't be so quick to forget.

After all, 36 tech funds closed in 2001 alone, followed by another 32 the next year, according to Morningstar.

So why, after all that, would the industry introduce a slew of products to capture a falling market? One bound to end in tears for both the funds and their investors?

"Investors have a psychological bias to think returns will persist, and the superficial story is that real estate will continue to perform well and the market will keep going up," says Charles Trzcinka, finance professor at Indiana University's Kelly School of Business.

"The funds are taking full advantage of this demand to bring in high fees."

As of Nov. 30, the three worst-performing newcomers were the (EURAX Quote - Cramer on EURAX - Stock Picks)Cohen & Steers European Realty A Fund (EURAX), down 26.2%, the (SAREX Quote - Cramer on SAREX - Stock Picks)S.A. Real Estate Securities (SAREX), which sank 18.2%, and (EIIGX Quote - Cramer on EIIGX - Stock Picks) E.I.I Global Property Institutional (EIIGX), 10.8% underwater since its launch.

The Cohen & Speers fund is filled with mostly international stocks. But the S.A. Real Estate Securities fund holds many domestic companies such as Simon Property Group (SPG Quote - Cramer on SPG - Stock Picks), Vornado Realty Trust (VNO Quote - Cramer on VNO - Stock Picks) and Boston Properties (BDX Quote - Cramer on BDX - Stock Picks).

The best performer of the group was (AGRNX Quote - Cramer on AGRNX - Stock Picks)Aston/ABN AMRO Global Real Estate (AGRNX), which is up 1.2% since it launched in August.

Part of the problem is that investors tend to chase returns, so a company that doesn't have an offering in the hottest sector is likely to lose assets to a competitor. They have an incentive to launch offerings at the wrong time just to hold on to the assets they already have.

"The fund companies are afraid of missing the boat, and you can't expect them to be charitable organizations. But the way things work is a little shifty," says Clifton Green, an associate professor of finance at Goizueta Business School at Emory University.

Trzcinka notes that it is all the more tempting for fund companies to launch new offerings at the top of the market, because investors are generally willing to pay higher management fees for access to a hot sector. "I would predict that these funds have higher fees than the average fund," says he says. "Investor rushing into hot funds tend to be less fee-sensitive, because they believe the funds will always go up, so you can charge more.

In a 2002 study, Trzcinka calculated that the average retail investor who bought into the tech bubble at the wrong time lost an annualized 31.6% from 1998 to 2001. The study also concludes that technology funds destroyed $30.5 billion of shareholder wealth.

In short, investors need to take responsibility for their money and stop chasing returns.

For those who got into REIT funds too late, there is a silver lining: If you sell them today, you can write off your losses against this year's taxes.

Coming up next: MVC Capital is Worth Another Look