When Dean Witter Capital Growth Securities Fund returned 48% in 1991--its first year out--investors who bought in early thought they'd found the next Magellan. Its strategy made perfect sense: The fund held only stocks of high-growth companies in recession-proof sectors such as health care and consumer staples. But just one year later, it crumbled under the threat of health-care reform and an improving economy. Negative returns for the next four years sent the star fund crashing to the bottom of the growth-fund universe.
The comet effect--soar, sizzle, and burn--strikes many new equity funds, and that's precisely why investors should think twice before jumping in early. "In a majority of cases, the potential of a new fund is three parts hype and one part reality," says Michael Hirsch, chairman of M.D. Hirsch, a unit of Freedom Capital Management in New York. Fund families tend to launch their newborns around trendy themes or give them big-name managers and other benefits. But such advantages usually fade with time and asset growth. Indeed, new funds frequently fall victim to a Catch-22: The better they perform, the more money they attract. But the bigger they become, the harder it is for them to do well year after year.
Still, many investors can't resist them. Equities have been on a long bull run, and the number of new funds keeps growing--474 have been added to Morningstar Inc.'s 6,730-fund database so far this year. The temptation to invest in newbies is understandable, since 61% of all equity mutual funds are less than three years old, according to CDA/Wiesenberger, a Rockville (Md.) mutual-fund data service. In fact, nearly one-third of all money flowing into equity mutual funds in the past 12 months went to those with less than a five-year track record, says State University of New York at Buffalo finance professor Charles Trzcinka.
JUMP START. Before plowing your money into a new fund, keep in mind why first-year performance is often misleading. For starters, new funds have an inherent advantage: modest size. Small funds can move in and out of the market quickly as they discover promising new stocks or sectors. But billion-dollar behemoths are not as agile: They're forced to own more companies and more shares to achieve the same effect.
The meager asset base of new funds encourages big fund families to give them a jump start. For example, big fund groups tend to give startups higher allocations of scarce initial public offerings (IPOs). Whether the small fund holds the shares or immediately flips them back into the market for a fast profit, even the slightest price appreciation has an impressive impact on its performance. How much a new fund depends on IPO flipping for short-term gains is hard to trace. The strategy works well for small-cap funds, but for funds with less-aggressive objectives, the quick spikes in performance can mask a lack of investment prowess.
Playing to an investment theme's popularity is another way fund families jolt returns. Unfortunately, by the time the fund debuts, the sector is often at the height of its popularity, so most of the money already has been made. "All fund companies are guilty of giving the public what it wants," says Bob Perkins, manager of Omni Investment Fund in Chicago. "But too often, what it wants is yesterday's winner." In 1991, it was health care and Latin America, while 1993's crop of funds focused on real estate. Technology is today's fund du jour. "Before you jump in, you have to question whether or not you are getting in at the bottom of the eighth inning," advises Minneapolis money manager Bob Markman.
What today's investors also want are fund managers with celebrity status. Often, a famous manager is a positive. But increasingly, fund families are leveraging the talents of well-known managers to run two or more types of funds--and spreading their skills too thin, says San Francisco money manager Ken Gregory of Litman Gregory & Co. Take the example of Jim Craig, the highly successful head of the large-cap Janus Fund, who managed the newer small-cap, Janus Venture, before conceding he had too much on his plate.
Bootstrapping, or cherry-picking, is another way to give a new fund an edge. Here's how it works: Say a fund family's research staff discovers the next Netscape Communications. The small fund buys the shares first. Then, the larger fund helps the share price along by buying it in bulk, creating a feeding frenzy on a particular holding and enhancing the performance of both the new and older funds. Some believe this creates a conflict of interest. "Many large fund families have only one trading room, so it's entirely possible that trades could be allocated in ways to benefit new funds or certain managers," Trzcinka says.
Getting first crack at a promising issue is a good way for a new fund to boost returns, though it doesn't help the shareholders of larger funds that may be second or third in line. For that reason, fund companies don't readily endorse this practice. But fund watchers say it occurs. "This Chinese wall that is supposed to be built between funds within the same family really crumbles at times," says Gerald Perritt, manager of a small fund, Perritt Capital Growth, and the author of Mutual Funds Made Easy! ($9.95, Dearborn Financial Publishing).
STAY FAD FREE. While new funds often enhance their initial performance, there are still times when getting in early makes sense. So if you're tempted by new issues, protect yourself by following a few basic rules. First, you stand a better chance of sustaining good results if you stick to new small-cap funds. A 1994 Value Line study shows that small-cap equity funds that start out strong continue to be top performers in their class, albeit to a lesser degree, 10 years after inception.
Second, avoid investment fads and stick with a strategy you understand. Third, know the manager. Make sure they have an established record within the fund's discipline. If the manager is new to the fund family, check out his or her experience elsewhere, either at another company or overseeing private accounts. Assessing today's crop of managers is complicated by the fact that the market has been moving steadily upward for the past five years, making almost everyone look good, says Geoff Boboroff, a mutual-fund consultant in East Greenwich, R.I.
For that reason, Hirsch only recommends new funds when they are proven concepts run by seasoned managers who stick to their speciality area. When the managers of small-cap value fund Pennsylvania Mutual introduced a similar fund, Hirsch liquidated his assets in the larger fund and bought the new one, Royce Premier. So far, he looks smart. Royce Premier's three-year annualized returns were 18%, vs. Penn Mutual's 12.4%. "The key is to find old wine in new bottles," agrees Markman, who frequently recommends the latest offerings of such well-known managers as Michael Price of the Mutual Series funds and Jean-Marie Eveillard of SoGen.
Whenever possible, look for ways to keep costs down. Fund companies sometimes waive fees or lower expenses on new funds as an incentive to draw investors. If the fund meets all of the other criteria, go for it. The extra 1.5% return will be a gift.
Ultimately, it's better to avoid new mutual funds with stratospheric early returns. Why reach for shining stars that may burn out quickly when there's a whole universe of more subdued--but proven--lights to choose from?