Investors have notoriously short memories--and in those who invest in mutual funds, it's an understandable flaw. In the past four years alone, millions of people flocked to funds, and the billions of dollars they invested fueled torrid stock and bond market rallies. For them, there are no long-term memories of well-meaning investment strategies gone awry. Until this year, most raked in money.
But investors should now be heeding a lesson from the old days--which, in the world of mutual funds, is 1990 or earlier: Don't invest in a mutual fund until it has racked up a five-year track record.
Paying heed to this simple dictum would have kept investors out of the PaineWebber Short-Term U.S. Government Income Fund, launched in 1993. The fund, promoted as a higher-yielding alternative to money-market funds, in fact was loaded with volatile mortgage-backed securities. They plunged in price this year, dragging the 1994 total return (change in net asset value plus reinvestment of dividends) to -7.7%. Contrast that to the Vanguard Fixed-Income Short-Term Federal Bond Portfolio, with a similar investment goal. It is down just 0.9%.
SURER PROTECTION. For now, PaineWebber Group Inc., the fund's parent, is practicing damage control. On July 22, the brokerage firm said it would spend $180 million to buy the fund's unsalable securities. That's on top of $88 million spent in June to buy other illiquid assets and, if a court approves, restore 6 cents to each fund share's net asset value. PaineWebber's efforts may stem further losses, but they're not going to make fund investors whole. Funds aren't obligated to make good when they lose money, and investors can't count on any bailouts.
The five-year rule is surer protection. That's about the length of time it takes a fund to experience bad as well as good times in the market. Many pros who use mutual funds to manage their clients' money won't touch a fund until it has racked up five years. And BUSINESS WEEK won't rate a fund in its annual Mutual Fund Scoreboard if it has less.
If investors actually practiced the five-year rule, it would crimp an industry that is creating funds willy-nilly. Since 1990, the number of funds soared 55%, to 4,828 (chart). But hey, it's the investor's money that counts--not the manager's Mercedes. And, of course, there are exceptions. If a fund manager with a proven track record is going to launch a new fund using the same investment approach, there's no need to wait. And it's important to remember that even the best fund managers sometimes hit a slump.
The five-year rule is especially helpful when it comes to testing the durability of new investment concepts. Investors who took a wait-and-see attitude would have missed the debacle in the government bond-option funds that soared in 1985 and 1986 but crashed in 1987. Those following the five-year rule also would have avoided short-term world income funds, introduced in 1989 to capture the higher interest rates of non-U.S. markets while eliminating currency risk through sophisticated hedging strategies. Those funds worked fine for three years. Then a financial hurricane blew through Europe's currency markets in 1992 and made the hedges worthless.
For sure, fund buyers who wait five years may miss some winners. The Oakmark Fund, which celebrates its third anniversary on Aug. 5, has racked up a juicy 150% return. Investors willing to do the homework may be able to spot such gems among the new funds. But for most, sticking with a more seasoned vehicle is safer. Investors who do so may miss some big runups, but they have a better chance of avoiding the worst of what the fund industry has to offer.