Internet Fund's Five Stars Highlight Risks Behind the Rating

The (WWWFX Quote)Internet fund has it all: high risk, untested management and now a five-star rating.

Chicago-based fund-tracker Morningstar just awarded its top five-star rating to the $825 million fund, even while cautioning that investors should think long and hard before diving in.

"This highlights why we tell people never to buy funds on the star rating alone," says Morningstar analyst Scott Cooley, who adds that investors should consider the fund's considerable risks before buying a share.

A coveted five-star rating can draw investor attention and dollars. Industry leaders routinely state that the majority of fund investments flow into highly rated funds, year-in and year-out.

"The two fund groups that consistently sell best are five-star funds or new funds that people are excited about because they have a big marketing push behind them," says Andrew Arnott, general director of product management at the $31.7 billion John Hancock Funds in Boston.

Like its Net peers, the fund focuses on a risky, but growing niche of the volatile tech sector. The fund is also nondiversified, so it can build big bets in relatively few stocks. On Oct. 29, the fund's largest position, cable programming provider Liberty Media (LMG.A Quote), was less than 6% of the portfolio, but its top 10 holdings represented a whopping 41.8% of assets, according to the fund's Web site.

Also, Ryan Jacob, the manager who built much of the fund's record left at the end of June to start his own fund. Since then, Peter Doyle and Steven Tuen have run the fund. In addition to their portfolio management duties, Doyle is chief investment strategist and chairman of the fund's adviser Kinetics Asset Management and Tuen is research director of IPO Value Monitor.

Doyle and Tuen's representatives didn't return a call for comment, but Morningstar's Cooley says they've shifted the fund's focus away from pure-play Net stocks. Top holdings on Oct. 29 were broader plays. In addition to Liberty Media, they include two telecommunications concerns, RCN (RCNC Quote) and Telephone & Data Systems (TDS Quote).

It doesn't look like the moves paid off immediately. The fund lost 11.6% in the third quarter. That ranked it last in both Morningstar and Lipper's tech-fund categories for the quarter.

In the fourth quarter, the fund has climbed out of the cellar, but not by much. From Sept. 30 through Dec. 2, the fund's heady 32.7% return actually lags the average tech fund by nearly 4 percentage points and ranks 78 out of 123 tech funds, according to Lipper.

So, how did the fund get five stars?

The rating is awarded to domestic stock funds that rank in the top 10% of all U.S. stock funds, regardless of category. (A fund also must have a three-year record, a requirement the Internet fund just met.)

While the star rating highlights many solid funds, it also favors hot fund categories. And tech is as hot a category as there is. The average science and technology fund has gained 94% in 1999, according to Lipper.

So, it's no surprise that the average fund in Morningstar's technology category sports five stars for the latest three-year period. (ATCHX Quote)Amerindo Technology, a Net fund that's known as one of the riskiest around, got a five-star rating this year, too.

Since the fund's October 1996 inception, it has ridden Internet stocks to eye-popping returns: 175% in the year to date and 105% annually over the past three years as of Dec. 8. Morningstar's ratings system does take risk into account, measuring each U.S. stock fund's downside volatility vs. all other domestic stock funds. But the Internet fund's triple-digit returns still make the fund look like a good bet.

"If you look at the guy who bought the winning lottery ticket, buying a lottery ticket doesn't look too risky," Cooley says.

But for those looking for better odds on their money, a wait-and-see approach for the Internet fund makes sense.