A New Fund Rides the Big Mo'

Based on the momentum theory that rising stocks tend to keep rising a while, Rydex' method has been racking up some good numbers. But there are caveats

Hideous truth hurts, but here it is, a recap of the New Millennium: $10,000 invested on Jan. 1, 2000, in the Wilshire 5000 Total Market Index was worth $7,124 by mid-June. In the typical aggressive-growth mutual fund, 10 grand shrank to 6.4 grand. In the Munder NetNet Fund, it sank to $1,533. If you had $10,000 in stock of Lucent Technologies, it was down to shares worth $526. Enron? $24.11.

Amid this depressing reality, the fastest-growing new mutual fund has sucked in more than $100 million in just 12 weeks. Rydex Sector Rotation Fund is the latest invention of Rockville (Md.)-based Rydex Funds, which has gone from managing zero in 1993 to $5.5 billion. Its Sector Rotation Fund is catching on because investors "realize that just buying [equity] exposure and sticking with it isn't the way to go," the fund's portfolio manager, Charles Tennes, told me. "People like the built-in sell discipline."

What he means is his fund does not hold anything unless it's hot. Tennes examines 59 industry groups of stocks each month and ranks them by their price strength over the prior year. Next, he picks the top dozen or so industries and buys enough stock from each to give each industry an equal weighting in his portfolio. Recently, that yielded a fund with about 200 stocks from 14 groups (table). Next month, Tennes will dump stocks from any industry falling out of the top ranks and add stocks from comers.

Based on the "momentum" theory that rising stocks tend to keep rising, sector strategies are nothing new and have a mixed record. But in a hypothetical "backtest," Rydex' model beat the Standard & Poor's 500-stock index by a mile--an annual average return of 26.6% vs. 12.7% in the six years ended last Dec. 31. Those results confirmed similar tests by S&P Chief Sector Strategist Sam Stovall, author of the book, Sector Investing. He sees the fund as so promising that he put some of his own money in it.

Yet before you hide from the bear in sector rotation, it's worth seeing just how safe a spot this fund might be. First, it isn't cheap. Annual expenses come to 1.8% of assets, and are higher yet, 2.55%, if you buy the Class C shares sold by brokers. Morningstar puts the average domestic stock-fund cost at 1.44%. Second, there's a strong chance the fund will trade often, perhaps creating a steep capital-gains tax bill. So the fund is a bad bet for taxable accounts. Stovall, no fool, bought his fund shares in a tax-deferred retirement account. He also notes that investors should resist putting their entire equity allocation into sector rotation. "It's not a conservative approach" to investing, Stovall told me.

The big danger can be seen from the table on this page: What are hot at any time tend often to be similar sorts of stocks--right now, for example, it's food, household, and other tame plays. Because the fund is less diversified, its value figures to fluctuate more wildly than the market. In the backtest, the Rydex model was much more volatile than the S&P 500.

The second worry is whether Tennes can do as well or better than the model, which in the backtest ran mechanically. For example, it chose exactly 10 industries each month, while Tennes picks industry groups making up roughly the top 20% ranked by performance. That could be 10 industries, or a few more or less. Tennes also uses as much gut as science in deciding whether to keep, say, a key industry stock that's up a lot on merger talk. A backtested model "is stupid, and we like to think we're smarter," Tennes said.

In its brief life, the fund is off 3% compared with a 12% loss in the S&P 500. For most money managers, that's fine work. However, Tennes won't be happy unless the fund makes money. In a bear market, that may be more than investors can reasonably count on.

By Robert Barker

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