Why Your Mutual Fund Never Seems to Be the Hottest One

Have you ever seen those ads in the magazines and newspapers about funds that have increased substantially in a year? And you wonder why you never own those funds? Do you get the feeling that as soon as you buy funds, they fall in value

You're not jinxed. There could be a reason for this and I'll explain why.

Some people are attracted to funds that have had a recent strong performance. Such a fund might get written about in magazines and in the press. In response, many investors might be inclined to send in large amounts of new money to this seemingly hot fund. The size of the fund swells, but the performance might start to worsen. How can that be?

Maybe this comment from an SEC Commissioner will provide insight:

"Let me further illustrate what I mean by describing two enforcement actions, both of which involved, at least in part, misleading advertising. Both of these cases, Van Kampen and Dreyfus involved a fund's failure to disclose the effect of "hot" IPOs on performance results, and that the fund would be unlikely to sustain the good performance.

In Van Kampen, the fund advertised a 61% one-year return and a #1 Lipper ranking, but did not disclose that investments in IPOs had a large impact on the fund's return, and that it was unlikely that the fund could sustain that performance as the fund grew in size.

In Dreyfus, like Van Kampen, the fund advertised its spectacular one-year return, without disclosing the large impact that IPO investments had on the fund's return and without disclosing that it was unlikely that the fund could replicate its prior performance as the fund grew in size. In Dreyfus, the Commission specifically stated that the ads were materially misleading and failed to comply with the antifraud provisions of the federal securities laws, even though the fund's ads complied with Rule 482." ⁵

As the SEC further explains:

"Newly created or small funds sometimes have excellent short-term performance records. Because these funds may invest in only a small number of stocks, a few successful stocks can have a large impact on their performance. But as these funds grow larger and increase the number of stocks they own, each stock has less impact on performance. This may make it more difficult to sustain initial results."⁶

Once everyone sees how well the fund does, they may be inclined to pour in new dollars, the fund invests the new money and now the fund has say 200 different stocks. Now, it will usually take more than a few good stocks to make this bigger fund perform at the same level that it has in the past. So the performance trails off and it might seem as if everything suddenly went sour as soon as you invested.

Another possible factor has to do with public perception. For instance, one industry such as biotech might be doing very well for the moment. As those funds appear to be doing well, then the public jumps in. However, they may be getting in just as that sector is cooling off. Lipper Inc. Researcher Andrew Clark says, "For the majority of equity funds, superior performance does not appear to persist." In other words, funds that produce substantial returns for a given year will usually not continue to consistently produce such results forever. ⁷

I always advise people to consult with their own qualified legal, tax, and financial advisor prior to making any financial decisions.

If your pursuit of these so called "hot funds" does not appear to be paying off, a more consistent asset allocation program may be for you, rather than to the markets' latest fad (although asset allocation does not guarantee against the risk of a loss in a declining market, it can help reduce your overall market volatility risk).

If you would like to meet either in person or by telephone, or simply would like to receive my FREE 35 page "Investor Awareness Guide", please use the CONTACT US link and let me know.

I look forward to meeting you!

¹ Mutual Fund Investing: Look at More Than a Fund's Past Performance, SEC Website
¹ "Why hot mutual funds don't stay hot", Chicago Sun Times May 10, 2004
⁵ Speech by SEC Commissioner Paul R. Carey U.S. Securities & Exchange Commission March 2, 2001 Mutual Fund Performance Advertising: Is It in Overdrive? The IPO issue on fund performance was raised again :Testimony Concerning Recent Commission Activity To Combat Misconduct Relating to Mutual Funds by Stephen M. Cutler, Director, Division of Enforcement, U.S. Securities & Exchange Commission Before the Senate Committee on Banking, Housing, and Urban Affairs November 20, 2003