Beware the Value Boom

There are plenty of snazzy new value funds on the shelf, but you should probably stick with dustier ones that have been on the market for years.

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The ranks of tech-light, bargain-hunting value funds have quietly but dramatically swelled in recent years. Today there are some 630 on the market, compared with 389 just five years ago, according to Chicago research house Morningstar. The geyser of young offerings is at least partially the result of fund companies with growth-heavy menus trying to branch out, now that value funds have seen higher returns and inflows than their tech-sick growth peers.

What many fund companies and investors have discovered, however, is that a rising tide of value funds doesn't mean there's a rising tide of talented managers to run them. And launching a value fund doesn't make you a successful value investor, as illustrated by the disappointing early returns of the (JSVAX)Janus Strategic Value fund and other rookies.

The situation is yet another example of the herd mentality and bloated state of the fund business. It also underscores the fact that there's little reason for you to bother sifting through the deepening bin of young funds when there are plenty of solid choices with longer track records.

"This really adds to the clutter you have to wade through to get to good funds," says Bryan Olson, a managing director at the Charles Schwab Center for Investment Research. "Just about any type of value fund you'd want to buy is already available and has a solid, veteran manager. You can afford to be selective," adds Scott Cooley, a senior fund analyst at Morningstar.

Of course there's been a gush of new funds of virtually every flavor over the past 10 years. Thanks to a bonny economy and a bull market that imbued pro and amateur investors with a nearly religious faith in 20% annual returns, mutual funds now outnumber the number of stocks traded on the New York Stock Exchange. The glut of new growth funds that launched during and after the tech mania is well documented, but value funds have had their own mania mainly, due to two familiar catalysts: solid returns relative to the S&P 500 and healthy inflows.

The Value Boom The number value funds has jumped over the past five years

Source: Morningstar. Data through Jan. 31.

After big-cap tech stocks peaked in 2000, investors sought shelter in cheap stocks in general and small-caps in particular. Last year's top-performing stock-fund category was small-cap value funds, and they averaged an 18% annualized gain over the past three years, compared with a 2% annual loss for the S&P 500. Mid- and large-cap value funds are also trouncing the index and their tech-sick growth peers over the past three years.

As usual, index-beating returns drew investors' dollars. After suffering net redemptions in 1999 and 2000, value funds took in some $65 billion last year, more money than they'd gobbled up in the past five years combined. Redemptions from big-cap growth funds outpaced investments by more than $20 billion last year, according to Boston fund consultancy Financial Research. The same pattern continued this past January as value funds' take topped $9 billion, compared with just over $2 billion for growth funds.

One problem, however, is that you can launch a slew of new funds, but there's no guarantee that there is an equal number of talented, tenured value managers looking for work. Particularly since most young managers chose to follow the racier growth style during tech's bull run.

"I think you might have a talent drain in the value camp," says Bob Martorelli, co-head of Merrill Lynch's value team. "I think it would be difficult to staff a value fund with talented people now. A lot of young managers are interested in the growth style. They're more interested in a company's growth than its valuation."

Martorelli adds that several veteran bargain-hunters were "shaken out of the industry" during growth's market-leading run from 1998 through early 2000. Indeed, George Vanderheiden, longtime Fidelity manager, and Robert Sanborn, the high-profile value manager of the Oakmark fund, both left the industry just as the Nasdaq peaked and growth funds began to plummet.

Schwab's Olson likens the situation to that of major league baseball, where a spurt of new teams rapidly diluted pitching talent. Morningstar's Cooley says Sanborn's replacement Bill Nygren is "one of the youngest good value managers out there, and he's in his mid-40s."

Recognizing the paucity of talent out there, some firms have bought bargain-hunters, rather than train them in-house. Last year growth specialist Turner Funds bought three value funds from Clover Capital Management, slapping its own label on them and retaining Clover to run them.

Bill Nygren's Oakmark Select fund is shuttered to new investors, but he's also signed on to run the broker-sold (NRSAX)CDC Nvest Select fund in a similar style. And the team behind the well-regarded Clipper fund also runs a value fund for PBHG Funds.

It might seem like a cop-out to buy or rent talent from other shops, but not when you consider the plight of the Janus Strategic Value fund. Launched to much fanfare and just over two years ago, the fund attracted more than $1 billion from investors. But the growth shop's top value hand, David Decker, hasn't thundered out of the gate. The young fund fell 12% last year, trailing more than 80% of its peers.

No doubt too many funds, in value and growth categories, have rolled off the assembly line over the past few years, and many will eventually cash out or merge into larger funds due to modest assets and/or sagging performance.

The bottom line is that this predictable cycle is far more fun to watch when the funds in question aren't in your portfolio. So if you're looking for a solid value fund, check out some of the steadier types we've turned up in our Big Screen Archive, and think long and hard before you sink your money into a new fund run by a manager who's short on experience. There's just not much reason to bother.

As originally published, this story contained an error. Please see Corrections and Clarifications.

Ian McDonald writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to [e-mail], but he cannot give specific financial advice.