Securities and Exchange Commission's
recent crusade to improve mutual fund disclosure, there's still one thing you'll never hear from a fund:
Get out now. Performance is about to collapse.
So much for fair disclosure. However, you
be on the lookout for some telltale signs that a fund is about to falter. Here's a handy checklist of reasons you might want to dump a fund, or at least avoid it.
Hot returns might be the ultimate come-on for investors. But a fund's fantastic performance and its resulting popularity are two signs that it's on the verge of stumbling.
Too much money in a particular fund or investment style can kill performance. If everyone is throwing cash into a sector, there's not a lot of room for it to keep going up. As more people take a piece of the limited profits in one industry, they're all going to get less for their money.
Let's say that the widget industry is going to produce $100 billion in earnings over the next 10 years. If investors put $100 billion in that sector, they're paying a dollar for every dollar of future earnings. But even if people invest $1 trillion, those companies are probably going to earn the same amount of money. Instead, investors just paid 10 times more for those earnings.
The best case is you make no money. In a worse case, investors realize that paying $10 for $1 in earnings over 10 years is a bad investment. Valuations come back to normal and you lose. That gets back to one basic premise of investing: Pay a reasonable or cheap price for future earnings.
No sector of the market can keep going up forever. If you're thinking about investing in a gold fund right now, just think back three years and remember what happened to Internet funds.
And you can find plenty of ways to tell that a style is overblown or played: Everyone will be talking about that category. Every article is hot on the idea. And a fund is taking in new money faster than it can invest it.
You can easily track the funds and styles that are attracting the most investor cash. You don't need up-to-the-minute data -- just enough to follow the trends. Financial Research Corp. releases monthly data on fund inflows on its Web site at
www.frcnet.com. You can see the funds that are taking in the most money, which are the ones you probably want to stay away from.
Total Return bond fund was the best-selling fund for December and all of last year -- possible proof that the bull market in bonds is over.
Too Much Money, Too Few Ideas
Too much money can also wreck an individual fund's performance. A manager who is running a fund that has taken in a lot of cash might be forced to buy more stocks and larger stocks just to put that dough to work. And that can quickly change the style and makeup of a fund. A fund might be forced to take bigger positions in the stocks it already owns, which can ratchet up the risk.
A flood of new cash can be particularly damaging to a small-cap fund. Smaller companies have fewer shares that trade. A manager running a fund that's overloaded with money can't put enough cash in any one stock to make a difference in the fund's performance. And buying too many shares in any one tiny stock can produce dramatic swings in the stock's price, which can hurt the fund's returns.
You can keep an eye on a fund's assets to gauge how much money is coming in the door. You can also watch a fund's cash position. If that percentage is significantly higher than where it was a year ago, the manager might be having some trouble putting new money to work. And if the number of stocks the fund owns begins to multiply, that's another tipoff that the fund could turn from a leader into a laggard.
Royce Low-Priced Stock fund, for example, was a tiny $24 million fund back in 1999. But with the run-up in small-cap stocks in 2000 and 2001, this fund's size swelled. Today that Royce fund is almost 100 times bigger, with more than $2 billion in it. Three years ago, the fund owned about 55 stocks. Now that number is closer to 200. And sure enough, the fund's performance has started to lag similar small-cap funds.
To stem the inflow of money, this Royce could have closed its doors to new investors. It hasn't. (Mutual fund firms, after all, make money off the total assets in a fund.)
But even when a fund does close, it's usually happens too late. The fund's already too big. In fact, a fund cutting off new investments is a good sign that performance will weaken.
A Manager Hits the Road
When a top-notch manager leaves a fund, you might want to think about doing the same thing. If the person who built a fund's outstanding record is no longer there, its future is uncertain.
And you don't have to wait around to see if the new manager is a genius or an idiot.
A manager departure is one of the few signs you can rely on to tell if a fund's going to stumble. The SEC is never going to force fund companies to highlight and explain changes in their funds that could hurt future performance.
You're on your own.