Don't let the April rally fool you: The fund world is a much riskier place than it was just five years ago.
It's Not Growth vs. Value, It's Growth and Value
Foreign Funds Lower Risk, But Won't Do the Opposite of U.S. Stocks
Popular Funds Left You With a Tech Hangover
False Profits: Really in the Black?
Sector Addicts: Sector Funds Changing the Game and Not for the Better
Hocus Focus: The Downside of Focus Funds
If Now, Then How: Why Dollar-Cost Averaging Makes Sense
Cash Isn't King:1397846 Managers Don't Cash Out of Falling Markets
How to Build a Low-Maintenance Portfolio
Questioning the Buy-and-Hold Strategy
Historically, the idea behind owning a stock fund was that it gave you relatively cheap access to a broad portfolio of stocks that are in an index or on a professional manager's list of favorite 100 companies. When you bought shares, you knew it would rise and fall with stock prices, but less so. Well, that's not necessarily the case anymore.
Between 1990 and 1998 a total of five U.S. stock funds gained more than 100% in any calendar year, according to
. Then in 1999 nearly 130 domestic stock funds joined the
. Likewise, from 1990 to 1999 just four U.S. stock funds lost at least half their value in any calendar year. But last year, 23 funds joined the
, and in the year ending March 31, a whopping 220 U.S. stock funds made the cut.
Yes, those stark numbers are partially due to the stock market's schizophrenia in 1999 and 2000, but two trends in the fund business played a role: the growing prevalence of sector or even subsector funds, and the rising number of "diversified" funds that focus on 20 or so stocks -- compared with about 140 for the average U.S. stock fund.
"It's kind of amazing," says Russ Kinnel, director of fund research at Chicago fund tracker Morningstar. "Fund companies have been coming out with a lot more niche funds that focus on volatile areas and it significantly increases the chances that you'll get a 50% haircut. We've got Internet funds, biotech funds, B2B funds and on top of that we've got
focus funds, so an investor can get themselves in just as much trouble with funds as they could with stocks."
The average growth fund gained more than 10% in April and the average tech fund gained nearly 20%, so home-run slugging stock funds will be creeping back onto your radar screen. As part of this week's
Lessons From the Fall package, let's check out how we ended up with all these high-octane funds and why their big gains are often a prelude to big losses.
Big, indeed. Typically you figured your stock fund would chug along with the
at a 10% or 11% clip over time. Sometimes they'd gain a bit more and sometimes you'd end up losing money, but today many fund returns are downright stock-like.
Many of the funds on our list got there by shirking the fundamental tenet of every fund brochure ever written: Diversify. You'd expect many of the 220 Halftime Club funds to be tech sector funds, which are still down almost 50% on average over the past 12 months, even after a 19% gain in April, according to
In fact, 83 are tech funds and a
list of the 10 hardest-hit funds funds over the past 12 months is rife with tech and Net funds. But more than 120 are "diversified" growth funds.
The number of sector funds exploded in the second half of the 1990s. A rising tide on Wall Street masked the downside of pinning your hopes and dollars on just one sector. Reacting to investor interest, fund companies clamored to jump into the sector-fund game. The poster children of the sector-fund rush clearly were tech funds. At the start of 1995, there were 16 tech funds out there. Today the tally stands at more than 130.
It's easy to see why investors, armed with more information and emboldened by heady gains, clamored for tech-fund shares. The average tech fund beat the S&P 500 in seven of the past 10 calendar years, according to Morningstar. The category's 33% average loss in 2000 ended
a 15-year streak of positive returns. And in 1999 the average tech fund rang up a breath-taking 136% gain.
Despite these un-fund-like gains, most
model portfolios prescribe just a 10% allocation to sector-specific funds because they can fall in a hurry, too. But many investors blew right past that limit. Between 1990 and 1998 sector funds never took in more than 9% of cash flows to U.S. stock funds, according to Boston fund consultancy
. But they took in about 33 cents of every buck that went to domestic stock funds last year.
Sources: Financial Research Corp. and Morningstar
Again, tech funds led the way. In 1999 and 2000 they took in more than $77 billion, more than 10 times their previous record for in-flows over a two-year period set in 1995 and 1996. Fund companies launched wave after wave of sector funds, many narrowly focusing on subsectors like the Internet, business-to-business e-commerce,
alternative energy stocks to stand out in a crowd.
"Funds like these are turning people into stock strategists and I don't think they understand the risks they're taking," says Phil Edwards, managing director of
Standard & Poor's
global fund research unit.
Despite their diversified fund labels, "focus" funds carry a lot of risk, too. In the wake of
Janus Twenty's investment and marketing success, fund companies played the fund industry's favorite game: Me too. April buoyed many of these funds, but they lost more than half their value in the year ending March 31. Their losses over the past 12 months trail the vast majority their peers: Janus Twenty (minus 39.1%),
PBHG Large Cap 20 (minus 42.4%),
Conseco 20 (minus 49.2%),
Merrill Lynch Focus 20 (minus 52%) and
Berkshire Focus (minus 61.9%).
Even more troubling is that many growth funds that didn't sound like focused funds or sector funds acted a lot like both. At one point last year the average growth fund had some 40% of its money in tech stocks, and a look at the growth funds in the Halftime Club is pretty troubling. On average, they had more than half their money in tech stocks and packed more than 40% of their money into their top-10 picks.
"Yes, tech is broad, but at the end of the day having 40% or 50% of your money in tech means that there's an awful lot of risk there," says Morningstar's Kinnel.
The bottom line is that there's nothing wrong with owning souped-up stock funds. After all, 128 of these folks posted a triple-digit gain in 1999. The thing you have to remember is that those funds have lost more than half their value on average over the past year, and that's why they're only for the periphery of your portfolio, not its core.
That fall might not sound bad in light of 1999's gains, but since most of the money in those manic funds came through the door last year,
they provided a lot more risk than return.
Ian McDonald writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to
email@example.com, but he cannot give specific financial advice.