First off, this column isn't saying all trading is stupid.

It is not saying mindless buying and holding of any asset, mutual funds included, is always smart. It is not saying any attempt to get out of a fund or the market or a stock -- when you think the prospects are dim, or the gains have been made, or the manager leaves, or the valuations have changed, or the strategy changes, or for a host of other legitimate reasons -- is an exercise in futility.

The column is simply saying that very active trading in and out of funds is a losing strategy for your typical fund investor. It's one thing to say it, another to prove it.

Who's Hot, Who's Not

The fund industry has always been plagued by "hot" money -- investors who switch in and out of funds at a frantic pace in a never-ending hunt for the hottest craps table. Momentum-driven strategies differ slightly, but most try to get in whatever area of the market is going up.

Hot money investors, or "fund timers" as they prefer to be called, think there are good times to be in the market and good times to be out. They are correct. Finding them in advance is the tricky part.

Most fund families hate fund timers. They move massive amounts of money in and out of a mutual fund on a dime, sometimes going in one day and out the next. This hurts other investors, as it requires buying and selling portfolio investments to meet the whims of the traders, generating trading costs and adding to tax inefficiency. It can also stress out a fund manager. I know: A decade ago I used to calculate available cash for fund managers to allocate as a result of these frantic movements in and out of funds.

The problem has largely been dealt with by the industry by adding short-term redemption fees at both the fund and brokerage level or restricting numbers of "switches." Funds also routinely kick out investors they deem inappropriate, the fund company equivalent of reserving the right to refuse customers with a bad attitude or those not wearing a shirt or shoes.

Where Some See Trouble, Others See Opportunity

As more and more funds pushed out the black sheep, others saw opportunity. Rydex funds launched right when fund company repulsion with fund timers reached its zenith in the early '90s. The Rydex message was clear: Give me your tired, your sick, and most importantly your active, fund investors.

They greeted the scorned fund timers with open arms in 1993 and built a family of funds that let investors trade in and out to their heart's content. They allow investors to trade certain funds more than once a day -- as if to spite other fund companies' hatred of even once-daily fund trading. The strategy worked; today Rydex has over $6 billion in assets.

Success doesn't go unnoticed in funds. Copycat ProFunds launched a very similar lineup of highly tradable fund products in 1997 and has had success reaching a few billion in assets. ETFs also flourished in the '90s to help give these ultra-active investors a happy home.

Nobody knows exactly how much money is hot in mutual funds and ETFs (where the average holding period is often measured in days), partially because the money never stays still long enough to be counted. Combined assets in all these trader funds, plus estimating hot money still investing in regular funds, seeking the illusive high-alpha actively managed and tradable fund, could conservatively be estimated at $100 billion.

What all these products do is allow investors to trade funds effortlessly and without penalties or punishment. Many of the funds use derivatives to easily manage the inflows and outflows to the funds. It's the perfect design to fill a market need. From a fund family point of view, it's brilliant; from a fund investor point of view, less so.

Active trading of funds based on indexes presumes you can divine future index movements by some system, be it the 100-day moving average, advance/decline ratios, up and down volume, etc.

The Devil in the Details

To be able to prove fund timing does not work for most people, you have to understand how to determine profits at a fund. Looking at past performance can be misleading.

Imagine a fund has $10 million in assets and then goes up 100%. Then say the fund, after producing the big gains, draws investors to put $100 million in the fund. Pretend the fund promptly falls 25% in price after they invest the $100 million. At this point the fund is still "up" 50% in price, but your typical investor has lost 25% of their money, only a few original investors show gains of 50% in their accounts.

How can you tell what transpired at a fund without being privy to investor cash flows? Because fund investors leave a trail of their gains and losses in their wake, a little sleuthing through a funds annual reports can shine a light on what really happened behind the performance figures. Specifically, these reports show the funds realized and unrealized gains and losses from investing.

With the above example, the fund would have $5 million in unrealized gains and $25 million in unrealized losses on the books after the run up and subsequent collapse. If investors depart the fund, the manager may have to realize the losses and sell the depressed stocks. The main way gains can disappear from the books is when a fund pays out capital gains dividends.

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With good trading by investors, you would expect to see the gains produced by investors and left on the fund's books by trading into and out of the fund at least as good as, or even in excess of, the returns of the fund. If a fund goes down 25% and investors swarmed in, then sold out after the fund zoomed up 50%, massive taxable gains would be left on the books of the funds. Has this happened at some of these trader-oriented funds?

The ProFunds Bull fund is set to mimic the day's movements in the

S&P 500

. The fund, like the index, is down slightly since launched in 1997. The total assets in the fund on December 2002 was about $125 million. Realized and unrealized losses in excess of gains on the books was around $35 million. The fund has paid out minimal dividends, which means most people have lost money. If investors were good at trading in and out of the S&P 500, you'd expect less losses on the fund's books, if not gains or higher past dividend payouts.

The ProFunds Bear fund moves inversely to the S&P 500 and had about $78 million in assets at the end of last year. The fund is up since inception in 1997, and over the last three years the fund is up over 50%. There are no gains on the books. For some reason, these massive gains have been largely frittered away by investors, who apparently traded in and out at the wrong time. They lost money on the long and short fund.

Both of these families also have leveraged versions of many of their funds were investors can get equivalent of a 200% exposure long or short many indexes. Like giving a larger gun to a dangerous person, investors tend to get into more trouble with the extra oomph of leverage.

The ProFunds UltraBull offers 200% of each day's S&P 500 return. Total assets in the fund last December was around $73 million, accumulated net losses an astounding $155 million. The ProFunds UltraBear delivers an inverse 200% of the S&P 500 and is up an astounding 90% over the last three years but actually has losses of $12 million on the books. If investors just stayed put, they'd be rich!

When you combine margin and highly volatile tech stocks, the trouble compounds. The ProFunds UltraOTC brings 200% exposure to the already volatile Nasdaq 100. The fund had about $200 million in assets last December and a mind-boggling $1.9 billion in losses.

You'd think investors would have made a mint in the ProFunds UltraShortOTC since it moves in inverse proportion to the Nasdaq 100 with leverage and was up almost 50% in 2002 alone. The fund has over $107 million in losses, and $115 million in net assets. How could investors lose in both these funds?

In fact, 38 of the 40 ProFunds listed in the last annual report are sitting on losses. The only exceptions are the government bond and money market funds. The majority of investors trading these funds over the years have lost money, sometimes even in funds that are up.

The picture at Rydex is a bit less bleak. A handful of these funds, which have been around longer, show gains on the books. Ursa, which is inversely correlated to the S&P 500, and Tempest 500, which is double inverse correlated to the S&P 500, have made investors (as a group) money. But these two funds have about $1 billion in assets combined, and the gains of less than $200 million combined are not as much as you'd expect from funds up as much as these in recent years. These are exceptions; the majority of Rydex funds are also sitting on losses.

If investors could trade funds profitably, it could ruin these funds. They would buy low and sell high, leaving billions in taxable gains on the books of the funds, gains that would have to be realized and distributed to the few remaining shareholders as massive dividends. But there are no such gains left with the funds; fund timers are far more likely to leave losses, effectively trading at the wrong time.

Rydex and ProFunds are not to blame. They just run the fund casino; it's investors who lose money playing. Both are interesting fund families, giving investors unparalleled liquidity in and out of indexes and sectors long or short. Whether investors can benefit from such increased tradability remains to be seen.

Rydex launched the Rydex Sector Rotation fund on March 22, 2002, a fund that does the trading in and out of hot sectors for you. The fund is down about 21% since inception. Maybe they should stick to running the casino rather than betting in it.

The Rydex money-market fund has over $1.5 billion in it -- the money has to go somewhere between trades. Low rates on short-term bonds and high management fees mean investors are earning just 0.31% parking cash, waiting for the next big signal to buy. Hey, it beats losing money.

Jonas Max Ferris is a founder of MAXfunds.com, a fund research and analysis company, and partner in an investment advisor. He welcomes column critiques, comments, or baseless accusations at

jferris@maxfunds.com.