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Betting Against Fads in the Fund Industry

Imitation, the saying goes, is the sincerest form of flattery. In the financial services industry, it's often flattery that investors could do well without: A crush of similar products in a niche market is often a sign to run in the opposite direction.

A recent example is volatility funds. In January 2009, Barclays Global Investors launched the iPath S&P 500 VIX Short-Term Futures exchange-traded note (ETN) so investors could profit from moves of the volatility index. Stocks were near the trough of one of the worst bear markets in history, and volatility was off the charts. For frightened investors eager to hedge portfolios, a fund tracking the aptly nicknamed “fear index” seemed to fit the bill.

As it turns out, the VIX had peaked three months earlier at 89.5 and has declined ever since. The ETN plummeted, delivering an annualized return since inception of -63.7 percent through the end of March. Since it first was offered, some 28 other VIX-related ETFs have followed. Not surprisingly, most have performed poorly.

Following the Trend

The problem: When a niche fund attracts a following, others try to replicate its success. As money piles in, valuations become inflated, and the cycle continues until eventually the bubble bursts. “New fund products often follow the trend instead of anticipating it,” says Jeff Tjornehoj, a research director at fund tracker Lipper.

The pattern occurs over and over. In 2000, 94 tech stock mutual funds and ETFs were launched, according to Morningstar -- more than in any other year -- right at the peak of the dot-com bubble. From the end of 2000 through the October 2002 lows of the bear market, the average tech fund lost a cumulative 64 percent while the S&P 500 lost 31 percent.

In 2007 there were 16 real estate mutual fund and ETF launches -- more than in any year since 1997. Investors, viewing real estate as a defensive asset class, piled in. A year later, the average real estate fund fell 42 percent, while the S&P 500 fell 37 percent. And the same basic dynamic unfolded with managed futures funds when new offerings multiplied after 2008.

Contrarian Indicator

A current example of an overheating niche is energy master limited partnerships (MLPs), says Rick Brooks, vice president of investment management at financial advisory firm Blankinship & Foster. Investors like the hefty dividend yields on MLPs. Brooks has invested in them through a fund family called SteelPath. Lately, though, he’s been put off by all the money flowing into the tiny sector, which only has about 80 stocks. The number of funds investing in the niche has grown from one in 2009 to more than 20.

“All the money flowing in is driving up valuations potentially beyond where they reasonably should be,” he says. “When you’ve got that tsunami of capital coming in, fund managers feel compelled to put it to work, and you start seeing really bad investment decisions.” Brooks is contemplating selling his position.

Niche Fixed-Income Plays

New product launches don’t always mean bad news. A broader asset class such as bond ETFs, for example, has room for more funds without liquidity constraints. “You could point to a lot of the fixed-income investing over the last couple of years as indicative of a bubble in bonds,” says Tjornehoj. “People have been saying that for years now, but it’s been wrong. Fixed income has done pretty well, and asset flows have followed that direction.”

That problem is particularly worrisome in narrow, illiquid sectors. “Income-oriented ETFs focused on preferred stocks, global high-yield bonds, Canadian unit trusts and MLPs are being launched, and those are some of the most illiquid categories in the business,” says financial planner Louis Stanasolovich of Legend Financial Advisors in Pittsburgh. “If there’s a big redemption out of these ETFs, they are going to be trying to sell stuff that can’t be sold or at really bad prices.” Rather than pile into funds with a 3 percent yield, investors should focus on total return, he adds.

The Cooling-Off Period

Investors may do better if they wait until fund offerings in a hot area die down. After the dot-com bubble burst, 30 tech mutual funds were liquidated or merged out of existence. Only one tech mutual fund opened in 2002. After that year, from 2003 through March of 2012 the average tech fund delivered a 10.41 percent annualized return -- handily beating the S&P 500, which delivered 7.4 percent during the same period.

This strategy also works in broader categories. According to one Morningstar study of unloved fund categories suffering shareholder redemptions, buying funds from the three categories with the greatest redemptions each year produced an 8.98 percent annualized return from 1994 through 2011 compared to just 7.42 percent for the S&P 500. (In 2011 the three fund categories were large-cap blend, large-cap growth and world stock.) Buying into the flattery in funds, it seems, is an unprofitable exercise.

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