Caution: Buying New Funds Can Present Perils

June 12, 2003 -- While long-established mutual funds like Fidelity Magellan (FMAGX) and Vanguard 500 Index Fund/Inv (VFINX) remain the cornerstone of many investors' portfolios, the mutual fund industry never seems to tire of launching new products, accompanied by lengthy regulatory filings and slick marketing campaigns.

"Most new funds are trying to be opportunistic to respond to an investment cycle," says mutual fund consultant Burt Greenwald. "They're launched hoping that everyone will jump on the current bandwagon. It's just like fashion: when long skirts are in style, Bloomingdale's isn't going to sell you a short skirt, no matter how much it suits you."

Because those new funds are heavily marketed directly to investors, they present investment advisors with a dilemma.

"It's like being a doctor with all the prescription drug advertising that's on TV these days," says one Seattle-based financial advisor. "All of a sudden your patients -- your clients -- are coming to you asking for the drug they've heard about, even if it's not something that's right for them." That puts stress on the relationship between advisor and client, he adds.

A quick look at the history of new funds demonstrates the risks involved in snapping them up as they roll off the assembly line. When gold prices skyrocketed toward $800 an ounce, the industry produced a flurry of gold funds in time for the metal's slide in price. In the late 1980s, Japan funds were the rage: Since the Japanese market bubble burst in 1989, analysts say investors have made more on currency gains than through the stock investments themselves. A similar pattern was seen in the wake of Wall Street's infatuation with emerging markets in the mid-1990s, ending abruptly in 1997 with the emerging markets crash.

The most recent example is also the most dramatic: the short-lived infatuation of investors and mutual fund companies for "new economy" funds investing in Internet, technology and telecommunications stocks. For a time, new funds launched by companies like Janus flourished. But like many other fads, these new economy funds proved disastrous investments. A case in point was the Merrill Lynch Internet Strategies Fund, launched just as the market peaked in March 2000, raising $1 billion. Only 18 months later, the fund had only $125 million in assets, and was rolled into another Merrill Lynch fund.

"We are particularly bad at remembering that classic mantra about past performance being no guarantee of future performance" when it comes to new mutual funds, argues Geoff Bobroff of Bobroff Consulting Inc. "The class of 2003 is probably not going to look much better when we reflect back on it in 2006." Bobroff argues it is essential for investment advisers to ensure the new funds they recommend to clients aren't part of "yesterday's investment story."

The first step is to look at the nature of the fund itself. In the last three months, about 100 new open-end funds have been registered with the Securities & Exchange Commission, according to FundFiling.com. Of those, more than a third are bond funds or money-market funds, and another 10% or so are low-risk, high-income stock funds. (In contrast, about 15% of the funds launched in 2000 were bond or money-market funds, while technology and aggressive growth funds dominated new stock fund launches.) But with Treasury bond yields languishing at 40-year lows, pundits are almost unanimous in agreeing that sheltering in bond funds is risky.

"Interest rates have to rise," argues Greenwald, adding we may be in the midst of a `bond bubble.' "What you're seeing (in the flow of funds into bonds) is a replication of the craze for technology stocks that we saw in early 2000."

Fund advisors might be better off searching for new funds based on market themes that are still out of favor but which may look increasingly attractive in the coming months, analysts say. Some fund families are launching small company or mid-cap funds -- Delaware Management is introducing the Delaware BOB Small Cap Growth and Small Cap Value funds, while Pilgrim Baxter & Associates filed in April for the PBHG Mid-Cap Growth fund. Buffalo Funds' Buffalo Mid Cap Fund (BUFMX) is run by three veterans, and some advisors cite it as a potential winner if the sector starts doing better.

Steven Patterson of Sand Hill Road Advisors in Palo Alto, advises his wealthy Silicon Valley clients to put up as much as a third of their stock holdings into international stocks via mutual funds, even though international investing is still out of favor.

"Being in international stocks and in growth stocks have been two of the most unpopular places in the last few years," admits Sheila Hartnett-Devlin, chief global equity strategist at Fiduciary Trust. But that hasn't stopped Fiduciary from launching a new product, the Franklin Templeton Non-U.S. Core Equity Fund, which will be jointly managed by herself and a colleague at Templeton Funds with a combination of growth and value approaches. While inflows are slower than those into bonds funds, "this is the best time to launch," she argues. "You don't want to be doing it when everyone else is, and run the risk of being lost in the crowd."

But investment advisors need to consider more than just the sector of the new fund they are studying. Standard & Poor's suggests looking past the new wrapper and examining the quality and experience of the team managing the fund, as well as its track record and investment discipline. Both objective and qualitative information on portfolio managers and the structure of the firm is important, not only because it helps investors understand the fund better, but can provide guidance on what to expect going down the road.

Bobroff points out that it's also important to pay attention to how often the fund family launches a new product. "Some do it only rarely, when they think they have an important new theme or idea," he says, and funds like that warrant more attention from investment advisors.

Hartnett-Devlin urges advisors to look at how the fund family describes its expectations for the fund. Some use models to simulate historic returns, while others prefer the more rigorous -- but time-consuming and costly -- strategy of back-testing their new products.

"In the real world, there is often a disconnect between what a model suggests should happen and what does happen," she explains.

In a particularly uncertain investment environment, the best policy may be to treat new products with particular caution until managers demonstrate they know how to steer through rocky waters.

"Wait until it's seasoned," Greenwald says. "That's the best way to cut the risk of this year's crop of new funds."

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