Fund Investors' New Motto: Don't Do It Yourself

Like trapeze artists on crutches, fund investors are more interested in safety nets than in big leaps these days. And that's not a bad thing.

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As the Nasdaq bubble inflated in 1999 and early 2000, investors stuffed record billions into tech funds and other sector funds, which focus on stocks in just one sector or subsector rather than the broader market. These eye-popping inflows became a barometer of fund investors' confidence in their own ability to pick a hot corner of the market. They still are. Now that the bubble has popped and those heady gains are largely washed out of most investors' portfolios, sector funds just finished a year in net redemptions for the first time in more than a decade.

The upshot is that today, humbled investors are opting for broader, cheaper index funds, bond funds and financial advisers, implying that they still believe in owning stocks but don't necessarily have much faith in their own acumen. These humdrum tastes might not be sexy compared with two years ago, but they'll do more to boost most investors' assets over time -- if not their bravado.

"When the market goes up, you get confident and it seems fun, but it's not fun anymore," says Bryan Olson, a director at Charles Schwab's Center for Investment Research. Phil Edwards, director of Standard & Poor's global funds research unit, says, "I don't think [investors] have lost confidence in the equity markets, but they've realized it's hard to pick sectors. It seemed easy, but now they know it's not like that."

It certainly seemed easy. In 1999 the average tech fund rang up a stunning 135% gain, according to Chicago research house Morningstar. In an exaggerated version of a familiar cycle, those steep gains drew vats of ink from the press, oceans of cash from investors and a gush of new sector funds from fund companies that mostly carved up the surging but mercurial tech industry.

Because they're concentrated in one sector and therefore more volatile than diversified funds, sector funds shouldn't account for more than 5% to 10% of your stock portfolio, according to most asset allocation models. And sector funds never made up more than 9% of the total cash flows to U.S. stock funds in any given year -- until 1999.

Thanks to the tech sector's gaudy returns, sector funds took in more than 20% of the money that went into stock funds that year. The percentage jumped to 32% the following year as investors saw ads touting tech funds' past gains. Of the $68.5 billion gobbled up by sector funds in 2000, some $49 billion flowed into tech funds, according to Boston fund consultancy Financial Research. Before 1999, sector funds' record for inflows was $11 billion, set in 1993.

"We were absolutely overdoing it," says S&P's Edwards. "Sector funds should be used at the edge of a portfolio, but people were using them as core holdings."

The Rise and Fall of Sector-Fund Mania Seems confidence rose and fell with tech funds' cash flow in billions of dollars

Source: Financial Research Corp.; 2001 data through Nov. 30.

For their part, fund companies didn't seem too concerned. They slapped together sector and even subsector funds to capture sales. Since 1995, the number of tech funds has spiked from 140 to nearly 430.

Unfortunately, fund investors and fund companies jumped on the tech- and sector-fund bandwagons just as their wheels were about to pop off. Bonds have topped stocks in each of the past two years, and the average tech fund lost 32% in 2000 and 38% in 2001. Because much of these funds' sales came in late 1999 and 2000, many investors are deep in the red.

For an example, let's look at the wizened (PRSCX Quote)T. Rowe Price Science & Technology fund. It was the nation's biggest tech fund in 1999, with $12.2 billion, and today it has $3.9 billion in its coffers. Even if you'd been prescient enough to sink $10,000 into the fund on Jan. 1, 1999, prior to its 101% gain that year, you'd have had about $7,800 at the start of December 2001, according to the most recent data available from Morningstar. The same investment at the start of 2000 would've been worth less than $4,000. The picture gets bleaker when you consider that many investors were layering tech funds on top of tech-stuffed growth funds.

Given losses like that, it's not surprising that redemptions from sector funds outpaced investments by more than $9 billion last year through Nov. 30, according to FRC. Tech funds account for more than half of those net outflows.

It's also not shocking that rattled fund investors are entrusting their money to broad, cheap index funds and are seeking some advice. Last year's top sellers were decidedly less risky, including Vanguard's (VBMFX Quote)Total Bond Market and (VTSMX Quote)Total Stock Market index funds. Also, most fund sales came through financial planners and brokers in 2001. Traditionally, direct-sold fund shops such as Invesco and Scudder shifted into the adviser channel.

While this reaction puts investors' distaste for sector funds in stark relief, it doesn't mean these funds can't work if you keep them to 10% or less of your diversified stock portfolio. A portfolio with 90% of its money in Vanguard's (VFINX Quote)500 Index fund, which tracks the S&P 500, and the rest in the average tech fund would've beaten an index-only portfolio over the past five and 10 years, according to Morningstar. And over the past year, it would've lagged the index portfolio by only about 3 percentage points.

Moderation Sticking to the 10% would've been a good idea for long-term investors

Source: Morningstar. Data through Dec. 1.

The key, of course, is making sure the rest of your portfolio is diversified. If you replace the index fund with the average big-cap growth fund, the portfolio's near-term losses are much steeper, and it trails the index over the past 10 years, too.

If the hypothetical index fund/tech fund portfolio proves that sector funds can be useful, the past two years' losses have underscored the value of owning an index fund that offers broad, cheap access to stocks without outsize bets on the sector du jour. Fact is, if each year's fund-sales charts looked like last year's -- and they won't -- the average investor would probably end up with more money and more sleep.