New fund launches: too much of a good thing

January 2, 2007

We’re always looking for signs of overly exuberant fund investors to guide our investing decisions. When fund investors get very excited about a specific fund, a category of fund, or even investing in general, it often pays to do the opposite, or at least ease up on whatever is catching their fancy. New fund launches—their volume and relative asset-gathering success—are tops on our list of contrarian indicators.

A bountiful harvest of mutual funds was produced in 2006. No, we’re not talking about the strong global markets that carried most every stock mutual fund up in 2006—and more than half into double-digit territory. We’re talking about the bumper crop of new funds.

Many of these new funds are low fee—a good thing. Some of them offer interesting new ways to invest. Armed with nothing more than an E*Trade account and a few thousand dollars, today’s fortunate fund investor can go long and short on all sorts of indexes, sectors, styles, industry groups—even real estate, private equity, commodities, and currencies.

In 2006, more funds went public (offered stock to individual investors for the first time) than actual companies that sell things. And 2006 was no slouch for new stock offerings, either. We’re a country of finance, not widgets. Apparently there are more ways to package money to invest than actual companies to invest in.

Today, the buzz is all about exchange traded funds (ETF). ETFs have the excitement and tradability of stocks, with the sensibility of diversified mutual funds—only they are cheaper. That’s the pitch, anyway. ETFs often are based on indexes, though these days, the indexes really are just formula-driven lists of stocks created by the fund company—like “highest dividend stocks in the S&P500, equally weighted” or “health care stocks, ranked by market cap.” These days, we’re seeing about a dozen new ETFs a month.

What we’re experiencing now is nothing short of amazing. There were thousands of funds launched in the 1990s. Eventually, the number of funds passed the number of stocks listed on the New York Stock Exchange. The crash of 2000 was supposed to lead to a great consolidation in the fund business, as previous crashes had done. Sure, some tech and Internet funds closed (near the bottom of course), but by and large, the fund business remained very much intact.

Today, including all the share classes created for various sales channels, there are thousands more funds than in the bubble years. Investment company stocks—stocks of the advisors behind the mutual funds—have been among the stock market’s best performers in recent years. And why not? Collectively, they manage more than $10 trillion.

We’ve got nothing against new mutual funds. In fact, we’ve been covering them extensively since the last great fund-launching boom in 1999 on MAXfunds.com. But all this opportunity might spell trouble for investors.

The glut of new funds presents two big problems:

1) Investors tend to get into trouble with more targeted and risky investment choices. When you buy a more diversified fund, you can get into only so much hot water when, say, tech or oil stocks tank. The more concentrated your investment, the greater your downside.

Of course, you also can have a much greater upside. Unfortunately, most investors tend to buy after big runs have been made, then get burned in the eventual earth landing. Throughout most of recorded mutual fund history, the most volatile and focused funds have lost investors the most money as a percent of fund assets.

2) What is salable is rarely a good idea. Investor optimism is like fertilizer for funds. The greatest booms in fund launches occurred near peaks in the market: Before the crash of 1929 and before the Nifty Fifty wipeout in the 1970s. Far more funds were launched in the 12 months before the 1987 crash than the 12 months after—and those launched post-crash tended to be safer bond funds. And of course, the late 1990s was among the biggest boom times for fund launches.

Goldman Sachs launched a pile of speculative closed-end funds (the ETFs of their day) in 1929, and they quickly collapsed in the ensuing crash. When questioned about the logic behind the new fund launches, a partner said, “Well, the people want them.” Indeed.

As an investor, you’d have to look pretty hard to find something fundamentally wrong today. The economy is strong; employment is great; inflation is under control; interest rates are low; corporate profits are at record levels; per capita wealth is at all-time highs; home prices remain elevated, and the most invested-in stock index and the S&P 500 are still below record levels.

Probably the most frightening feature of this new “permanently high plateau” in the economy and stock market is the number of new funds. There simply can’t be this many good ideas.

There is nothing intrinsically wrong with an ETF; we’ve owned some in the past and continue to do so today in our model portfolios. In general, we tend to buy less popular ETFs. That said, the overall excitement for new fund products is one reason to lower expectations for stock market returns over the next few years.