How Fear Rules the Fund Flock

"There is a huge contingent of people in the OPM [other people's money] crowd who only care about beating the bogey [their benchmark index] and getting the horses that are moving the fastest," says hedge fund manager and Real Money.com contributor Bill Fleckenstein.

Fund investors should pay close attention to their funds' beta levels, which can be found on Morningstar's Web site. While growth funds understandably have a higher beta than value funds, levels far above 1 indicate bumpy rides ahead. (T. Rowe's Smith, for instance, sports a 1.08, an acceptable and relatively low risk level for a growth offering.)

The Costs

Richard Sias, a Washington State professor who has written extensively on "institutional herding," says institutional ownership levels have a far greater impact on a stock's movement than the company's actual earnings performance.

"If institutions are piling into a stock, as an investor I'd rather be with them than against them," Sias said. He says money managers move in packs because "they are looking at the same signals and, a lot of times, looking at each other's trades. It takes a while for everyone to get in."

While this leads to short-term surges in certain hot stocks and sectors, Sias said herd movements have negative longer-term implications as stocks get overvalued and the herd begins to sell en masse. He also noted that while institutional managers tend to pick stocks better than individual investors do, the costs of active trading are greater than the marginal benefits.

"The market isn't Lake Wobegon; we can't all be above average," Sias said.

Some fund managers acknowledge that the performance-chasing and overly active management may not be the best thing for their portfolios. At the annual Legg Mason Asset Management conference earlier this month, Value Trust manager Bill Miller, the only manager who has been "above average" against the S&P 500 for 11 years and counting, noted anecdotally that his fund would have performed better if it had remained static -- making no changes to its 2002 portfolio as it stood on Jan. 1. When his researchers went back to the beginning of 2001, they learned that a static fund would have outperformed the real-world, actively managed fund by a few percentage points. While Miller believes that high-beta (but not necessarily tech) stocks will pace the market's recovery, he hinted that a less-frequent turnover at his fund may be in store.

It is doubtful that the herd of fund managers will follow suit, says the University of Virginia's Dennis, who says overall volatility may keep rising as mutual funds continue to grow as a piece of the equity ownership pie. However, T. Rowe Price's Smith signaled that his firm's offerings may head in that direction as well. In responding to the reporter's question, the skipper acknowledged that many fund managers have gotten careless during the past few years -- chasing performance, taking their eyes off fundamentals, getting trade-happy. "We've realized we're good investors, but we're not always the best traders."