John Spence

Investors Buy High and Sell Low with Sector Funds

The pundits always lecture us about not chasing performance, but perhaps seeing the carnage investors inflicted upon themselves with ill-timed sector fund investments the past few years is the best way to make that lesson stick.

Fidelity launched the first sector fund for retail investors in 1981 and other fund groups soon followed, allowing investors to make concentrated bets on industries they believed would outperform. Since then there have been countless stories of unfortunate investors flocking into hot sector funds right at their performance peak.

Sector funds also tend to be pricier than diversified funds because they're smaller. For example, the 1,148 "specialty" funds in Morningstar's database have an average expense ratio of 1.75%. Average front-end loads are 1.32%, average deferred loads are 1.06%, and sector funds have an average 12b-1 fee of 0.45%.

Now, a rash of passive exchange-traded funds and HOLDRs tied to thin market slices has made sector investing cheaper and easier, but is that a good thing?

It's important to note that sector funds can be used to round out a diversified portfolio in certain situations. Also, many investors put a small percentage of assets into sector funds as "fun money" to keep their lives interesting without losing their shirts. However, history shows most investors are terrible at timing sector performance, and the fund industry happily accommodates them by launching and marketing new funds devoted to the latest hot industry.

Timing is everything

Morningstar Mutual Funds editor Scott Cooley looked at dollar-weighted sector fund returns in a recent article. Adjusting performance for sector fund net cash flows illustrates just how few investors participated in technology funds' dramatic rise, and how many were burned when the sector peaked in 2000. The table below shows performance data for the 386 tech funds tracked by Morningstar.

Although technology funds were an up-and-down ride, they still came out in the black with a 5-year annualized return of 3.03% as of the end of May 2002. However, Cooley found the dollar-weighted 5-year annualized return over the same period was -9.05% for all tech funds. A majority of investors clearly arrived late to the party.

At the risk of appearing sadistic, let's repeat the exercise, this time with the 55 communications sector funds tracked by Morningstar.

Again, dollar-weighted returns paint a bleaker picture than the 2.37% 5-year annualized return for the average communications sector fund. On a dollar-weighted basis, investors in communications funds lost 10.5% annually during the 5-year period.

Finally, Cooley found that the dollar-weighted returns for all sector funds for the time period was 1.85% on an annualized basis, less than half the 4.64% dollar-weighted return posted by diversified mutual funds. So much for timing sectors.

Supply and demand and performance

When the technology sector was surging ahead in the late 1990s, fund companies couldn't launch sector funds fast enough.

The funds posted extraordinary returns and soon became stuffed with new cash. Consider that before 1999, the highest amount of cash tech funds received in a year was $4.4 billion. In 1999 alone, tech funds took in more than $28.9 billion, according to Financial Research Corporation.

The largest Internet fund, Munder NetNet, raked in $3.7 billion in assets in 1999 during the height of the dot-com mania. The fund went on to lose an astonishing 54.24% in 2000 after the bubble burst, and Morningstar's Cooley found Munder NetNet scored a dollar-weighted, annualized return of -38.5% during the 5-year period in his study. Ouch indeed.

Lessons learned?

Although most investors have no doubt been inundated with tragic tales of investors getting wiped out chasing fund performance during the tech bubble, the bandwagon proves difficult to resist. Currently, investors are moving into outperforming bond funds in record numbers, despite the fact that equities have been beaten down. Buying low and selling high is the name of the game, but mutual fund investors seem to frequently get that one reversed. Although bond funds can diversify a portfolio and reduce risk, they shouldn't be bought simply because recent history has them outperforming equity funds.

"Mutual fund investors have to be the worst market timers in history of mankind, so the fact that bond funds are selling big right now should be a warning sign," said Morningstar's Cooley.