When Sector Funds Jump on a Gravy Train, It May Soon Derail

Fund companies keep jumping on to the tech gravy train, but that might be a sign that the tech train is about to go off the tracks.

Saying fund companies have launched a few tech funds this year is like saying Stephen King has written a couple of books: More than 60 of the 149 tech funds out there have launched since Jan. 1. But like a King tome, this story is rife with bad vibes and eerie omens. That's because as sector-fund investing bloomed in the 1990s, a disturbing pattern emerged: When fund companies roll out a record number of funds focusing on one sector or another, it often portends a submarket return for that sector in the next year.

Does this mean you should cash out your tech fund shares? No. But you should probably think long and hard about whether you really need more exposure to this mercurial sector, since a return to the glory days of 1999 might not be around the corner.

In the 1990s, no sector-fund category outperformed the S&P 500 the year after, fund companies launched the most rookies in its category. The jury is still out on tech funds, which gained a slim lead on the S&P 500 after a steep gain at the end of last week.

Bad Omens Just about every time a slew of fund launch in a given sector, it trails the market the next year, sometimes getting thrashed soundly.
Category	Gush Year	Sector Return vs. S&P 500 the Following Year
Natural Resources	1997	-53.9%
Real Estate	1997	-44.4
Financial Services	1997	-22.6
Telecommunications*	1999	-11.6
Health care	1997	-10
Utilities	1993	-10
Telecommunications	1993	-2.6
Technology	1999	+0.1
Source: Morningstar, MaxFunds.com, and Baseline. *The same number of telecom funds launched in 1993 and 1999.

In both 1993 and 1999 fund companies launched the most telecom funds -- three in each year, according to Morningstar and MaxFunds.com. In 1994 and so far this year, the category sagged, posting negative returns and trailing the S&P 500.

In 1993, fund companies launched seven utilities funds and the next year the average utilities fund stumbled to a 8.7% loss, compared with a 1.3% gain for the S&P 500.

Fund marketers christened the most sector funds in the financial services, health care, natural resources and real estate categories in 1997. Each category went on to trail the S&P 500's 28.6% return the next year, with a 4% loss for the four categories, on average.

And last year, 37 tech funds rolled off the assembly line -- the most in the 1990s -- and the average tech fund is down 5%, narrowly lagging the S&P 500's 4.9% loss, according to Morningstar and Baseline.

Given that fund companies have launched record numbers of telecommunications, health care and tech funds this year, these sectors' prognosis for next year might not be so bright, either.

What gives?

Fund companies usually launch funds in a given year's leading sector and one year's leader is often the next year's laggard. Remember last year when real estate fund, financial-services funds and health care funds were the year's lagging sector-fund categories? This year, they're three of the top-four U.S. stock-fund categories, with health care funds lording over the pack with an average return topping 50%.

Also, keep in mind that while stock-pickers are focused on timing the market, fund marketers are often timing you, watching where you put your money and launching a fund to slake your thirst for one sector or investment style. So they're often launching a sector fund once many investors' interest is already played out. In the past few months, several fund marketers, speaking off the record, admitted they didn't want to launch a sector fund but felt they had no choice given the cash flows into sector funds. Investment opportunities don't typically come up early in these conversations.

You can see the fruits of that type of me-too thinking. At the start of 1998, there were some 40 tech funds, and today there are 150, not even counting the vast pack of more than a dozen exchange-traded funds focusing on the tech sector. Over 60 tech funds have launched this year alone, according to Morningstar and MaxFunds.com. And there are a slew more just waiting for their paperwork to be approved by regulators.

Over-Teched You wouldn't think the world needs another tech fund, but even more are on the way.
Year	Tech Funds Launched
Pre-1995	18
1995	4
1996	9
1997	8
1998	11
1999	37
YTD	62
Source: Morningstar and MaxFunds.com.

The reason: The familiar pattern of hot returns followed by a geyser of investor dollars and a glut of new funds chasing that cash.

Tech Domination A look at tech funds' 10-year outperformance helps explain the snowballing of sector funds.
	Avg. Tech Fund	S&P 500
1-Year	60%	9.6%
3-Year	42.7	15
5-Year	30.1	20.9
10-Year	31.3	18.9
Source: Morningstar.

Tech stocks have led the market for the past few years, reaching a stunning crescendo in 1999 when the average tech fund posted a jaw-dropping 135% return, according to Lipper. So far this year investors have stuffed more than $44 billion into tech funds, accounting for more than 30% of total inflows to U.S. stock funds, according to Boston fund consultancy Financial Research.

From 1990 to 1998, all sector fund inflows never accounted for more than 4.8% of U.S. stock fund flows.

None of this means you shouldn't own a tech fund or tech stocks. Tech companies have revolutionized the business world and that looks to continue. This year many growth managers have said the only thing wrong with many tech companies these days is their thin-air valuations. Even though tech has taken a licking this year growth managers of all types have remained committed to the sector. The average large-cap growth fund -- the biggest stock-fund category with more than $530 billion -- had more than 44% of its assets in the tech sector at the end of September, according to Morningstar.

But all this does raise a central question: Do you really need more tech exposure? Asset allocation evangelists -- who've been about as popular as a traffic jam in recent years when it paid to bet the farm on tech stocks -- have always said you shouldn't slug more 5% to 10% of your portfolio into a sector fund. Recent cash flows indicate many of us have blown right through that 10% ceiling, so the answer may be no.

Of course, for many, investing isn't about following an asset allocation model or worrying about what will happen one year from now. For many, it's just about putting your money in the hands of managers whom you trust and in sectors whose long-term growth prospects make your palms sweat.

So if you think you don't have enough tech exposure and you absolutely, positively need to buy a tech fund, go ahead but try to pick a steady hand. Here's a recent TSC Screen that sifted the category for those tech funds that beat their peers over the past one- and three-year periods. And here's a primer on sector-fund investing to give you an idea of what you're getting into.

Once you pick out the fund and manager that suits you -- one whose best quarter raises your pulse and whose worst quarter doesn't send your lunch splashing on to the floor -- you also might consider dollar-cost averaging , investing a set amount each month. This method might not guarantee a profit, but it does reduce your overall risk by ensuring that you're buying more shares in tough months and fewer shares when prices are skyrocketing.

This will make you feel a little better if history repeats itself and all these new tech funds get dusted by the market in 2001. When fund companies tout hot funds they're required to tell you that past performance doesn't guarantee future results. In this case, they better hope that's true.

---

Apparently eBay is the place where fund company tchotchkes go to die. You can now bid on a charming promotional bull/bear puppet from John Hancock Funds, as well as gently used golf balls emblazoned with the Kemper Funds and Colonial Funds logos.

And no one has bid for a copy of Managing God's Mutual Funds: Yours and His, Understanding True Prosperity.

>To order reprints of this article, click here: Reprints