Fund investors might be loving sector funds a little too much these days.
While you might not be surprised to hear that investors fell hard for hot, techy sector funds after their heady gains in 1999, the depth of their affection is nothing short of stunning. Between 1990 and 1998, sector funds never accounted for more than 9.1% of total cash flows to U.S. stock funds. But in 1999, sector funds got more than 21% of U.S. stock funds net inflows. And last year that percentage jumped to a whopping 33%, according to data from Boston fund consultancy
Financial Research (FRC).
The situation illustrates a significant shift in the world of fund investing. Traditionally, the selling point with funds has been diversification. Now it seems many investors, armed with more information and emboldened by outsize gains, are favoring more aggressive or stock-like funds -- a trend fund companies, for better and for worse, are also fueling with a steady stream of increasingly focused sector funds.
Because most portfolio models for even aggressive investors recommend a cumulative sector-fund weighting of 10% or less, it seems pretty obvious that many investors blew right through that guideline. And most appear to have loaded up on tech funds, which attracted 69% of sector-fund flows last year and have more than $100 billion in assets, or about twice that of runner-up health care funds.
"I think that this is a reflection of the bull market we had. People started chasing returns without understanding the risks," says Bryan Olson, a director at
Charles Schwab's Center for Investment Research. "The biggest chunk of those people were chasing tech returns. I've met a lot of investors at conferences that are way overweighted to big tech stocks."
A Bigger Piece of the Pie
Over the past two years, sector funds have gotten
a much higher percentage of cash flows to U.S. stock funds |
 |
| Source: Financial Research. Data through Dec. 31, 2000. |
More than ever, they've been stuffing money into sector funds, primarily tech funds that rocketed to a stunning 136% average gain in 1999. Sector funds focus on one part of the economy like tech stocks or a thinner sliver like Internet stocks or an even thinner sliver like Internet B2B stocks. They can ring up breathtaking, stock-like gains -- as they did in 1999 -- and equally breathtaking losses -- as they did last year, when the average tech fund lost more than 30% and many lost far more.
The upshot: While investors loaded up on tech funds when they posted fat gains, many may have unwittingly made massive bets on the tech sector that led to painful losses last year.
Before 1999 the record annual cash flows to tech funds was $4.4 billion set in 1995, when the average tech fund gained more than 43%. Then in 1999, when almost eight of every 10 tech funds gained more than 100%, investors poured nearly $32 billion into tech funds. Last year, even though 97% of tech funds finished in the red, investors put another $43 billion into tech funds -- more than all sector funds' net flows for any year in the 1990s, according to FRC.
Going With the Flows
Tech fund flows have risen with performance over the last
10 years. Will they slip after last year's meltdown? |
 |
| Source: Financial Research. Data through Dec. 31, 2000. |
This tech obsession is understandable. After all, tech funds are the top-performing fund category over the past three-, five- and 10-year periods, according to Morningstar. If you'd invested $5,000 in the fairly vanilla
(PRSCX Quote - Cramer on PRSCX - Stock Picks)T. Rowe Price Science & Technology fund on at the start of 1991 you'd have had more than $46,000 in your account at the end of last year, even though the fund lost more than 34% in 2000.
Beyond big gains, tech funds have quietly been among the steadiest fund flavors out there.
As we've discussed in the past, 2000 was the first down year for the average tech fund since 1984 -- the longest streak of positive annual gains among all stock-fund categories, according to Morningstar.
But despite the glaring profits gleaned from the tech revolution, gulping down tech-fund shares often adds up to a huge bet. That's because your growth fund managers are doing the same thing. At the end of last year the average big-cap growth fund, the largest and most popular fund category in recent years, had more than 40% of its assets invested in tech stocks compared with 21.3% for the
(VFINX Quote - Cramer on VFINX - Stock Picks)Vanguard 500 Index fund, which tracks the S&P 500.
So, layering a tech fund on top of a growth fund adds up to a big, fat bet on one sector. This can boost returns, but it can really knock your teeth out when that sector cools off.
"The biggest risk in sector-fund investing is that a lot of people don't realize the risk they're taking," says Phil Edwards, S&P's head of global fund research. "If you already own a large-cap growth fund, you're already 40% or 50% in tech."
"In my utopia I'd like to think people meant to make a big bet, but most were probably just chasing returns without thinking about risk," says Schwab's Olson.
What's the big deal? Well, having an outsize tech stake can really ramp up your portfolio's volatility. Even if you had a broadly diversified portfolio you'd have lost money last year, but the losses would've been deeper if you'd had a tech-heavy portfolio.
The Price of the Ticket
A tech-heavy portfolio would've had better gains over the last
five years, but more recently it would've given you some
white-knuckle volatility too. |
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| Source: Morningstar. Returns through Dec. 31, 2000. |
A diversified portfolio's worst three-month stretch in the last three years was a 15.9% loss between last September and November, according to Morningstar. The tech-heavy portfolio lost more than 23% over the same dreary 90-day stretch.
Of course, the temptation to make a big bet on the sector du jour isn't going to disappear. Fund investors might be driving this trend, but fund companies are doing their part too by launching a stunning number of sector funds. In 1995 there were 140 sector funds. At the end of last year there were 375, according to Morningstar. Nearly two-thirds of the 123 tech funds out there are less than three years old.
"Sector funds were selling so more fund companies offered them," says S&P's Edwards. "Then because they offered and promoted them, people wanted them more. The
Fidelity commercials are a great example. A guy calls them and says he likes tech but doesn't have time to research tech stocks, then they've got a tech fund for him."
In fact, Fidelity has four different tech funds that slice the sector in different ways, not including its new
(FNINX Quote - Cramer on FNINX - Stock Picks)Fidelity Networking & Infrastructure and
(FWRLX Quote - Cramer on FWRLX - Stock Picks)Fidelity Wireless funds. The latest trend in fund product development departments is to launch a sector fund and then slice it thinner and thinner with other funds to stand out from the growing pack of competitors.
For instance,
Munder Funds offers three different tech funds, including two Internet funds, and
Kinetics Asset Management offers five funds that carve up the Internet into different slices. For an idea of how much riskier a sub-sector fund can be, consider the
(BTBAX Quote - Cramer on BTBAX - Stock Picks)Amerindo Internet B2B fund, which held just 12 stocks and had 15% of its assets pegged to online auction titan
eBay at the end of November, the fund's most recent portfolio report to Morningstar.
"Sector funds are riskier than diversified funds, but we're taking this to a new level when fund companies offer funds that are sub-sectors of sub-sectors of sectors," says senior Morningstar fund analyst Scott Cooley. "I'm not sure how much of a place a B2B fund has in many portfolios. It's pretty speculative. The real advantage of buying funds is diversification. And when you buy these funds you lose most of that benefit. Investors are the ones who have something to lose here. If the funds don't work fund companies will just liquidate them and they'll be forgotten, but the money lost will be real."
Fund companies are rolling out funds focused on last year's leader, health care funds, and the next new new thing,
new power or alternative energy funds. And tech funds are up 11.7% so far this year, according to Morningstar, so aggressive investors will have to temper their emotions. If they can't, fund companies will be happy but investors might end up with more volatility than they need or want.
Ian McDonald
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