Main Street investors should build retirement wealth with a do-it-yourself, well-diversified portfolio of eleven or fewer no-load index funds. Forget about Wall Street and their dazzling array of 14,000 funds, 8,000 stocks, hundreds of thousands of bonds and endless of new products with fancy names that Wall Street cooks up annually to entice you back into their high-cost casino that’s designed to make them more money, not you. Keep it simple. And trust yourself. Remember the trillions Wall Street lost in the last couple meltdowns. Don’t get sucked into chasing the “next big thing: “They don’t have it, and it’s not “out there!”

The way new funds are marketed reminds us of the opening scene of a Mission Impossible film: Tom Cruise dangling by one hand, clinging to a dangerous vertical rock cliff a couple thousand foot above the valley below, while intently listening to a challenging new assignment on his cell: “Good morning Mr. Phelps, a high-risk undiscovered fund just crossed our borders targeting the wallets of naïve American investors, it must be destroyed soon … this message will self-destruct in five seconds.”

In the past, when a buy’n’hold investor asked about a new fund—any new fund—the advice was always the same. Don’t buy it!. You already have thousands of funds with proven long-term track records to pick from. Besides, you only need eleven funds at most in your portfolio. So, why gamble on an unproven baby? Don’t do it. Never.

“Mad money” as an exception-to-the-rule

 Then I got to thinking, maybe I’m wrong. After all, psychologically, most investors are like Mr. Phelps. They love challenges, whether it’s mountain-climbing, Nascar, Vegas, Lotto … or undiscovered funds. Many are going to ignore the rules anyway. And besides, if you limit your higher-risk bets to less than five percent of your portfolio—to the “mad money” you can afford to lose—then you’re not risking your all-important retirement nest egg.

Okay, so this is market-timing (which the average investor should avoid), but if you’re going to ignore the basic principles of buy’n’hold investing and risk a little bit of your portfolio, at least make it a calculated risk. Wall Street knows how to play this shell game and sucker in naïve investors, so be forewarned. If you’re going to play, there’s one possible way of winning, an exception to the rule: “If you’re buying a new fund, do it early, ride it up, then dump it in 12-18 months.” Because after eighteen months, whatever edge a new fund has will “self-destruct,” like Mr. Phelps’ mission impossible tapes.

Ten factors super-charge new funds … for a brief periodResearch studies by Morningstar, Charles Schwab, Investors Business Daily, Wiesenberger/Thomson, Sheldon Jacobs and other reliable experts consistently prove that new funds do out-perform their peers: New small-caps beat their peers by three points or more, large-caps by a point … But their research also proves that after twelve to eighteen months, their edge disappears as new funds get old and “regress to the mean,” that is, gravitate to their peer group averages. How do new funds get their “edge?” They get it from a combination of 10 factors that collectively act like a booster rocket propelling the new fund from a dead start high into orbit. Then, like the first-stage booster on a NASA space shuttle lift-off, those same ten factors will fall away:

1. Front-end discounts. This is a common way of jump-starting a fund and pulling in new money. Although research also shows that as with introductory low rates on credit cards, the free ride never lasts long.
2. Fully-invested with low reserves. Redemptions are usually low the first year, so cash reserves are low and new funds tend to be fully-invested, resulting in higher returns. Later, higher cash ratios drag down returns.
3. Higher risks initially. If the prospective permits, managers can pump up early returns taking higher risk positions in startups, for example, investing in derivatives, high-yield debt and leveraging stock, tricks that attract media attention … and new investors.
4. More insider money. The fund management company may have more of their own money invested the early stages, giving them more of an incentive and more flexibility with investment strategies, similar to a stock IPO taking off.
5. Size limits investment choices. A small new fund has more flexibility in picking stocks of all sizes. But as the fund attracts more assets, it gets a lot tougher to find the right deals.
6. Fee waivers vanish. Once a fund starts performing, initial waivers tend to disappear. For example, every tenth of a point in management fee waivers in a $1 billion fund is $1 million bucks less to the manager.
7. Early home-runs score more points. Early on, a few successful buys on a small asset base can have a huge impact, and are often strategically placed there by a fund owner. But as assets grow, home-run hits have less effect.
8. Managers work harder up front. They have to prove themselves, fast. So the pressure’s intense up front. But once they see their game strategy is working, the pressure’s off.
9. Aggressive marketing and public relations. If early returns are hot, so is the fund’s marketing, and naïve journalists begin descending like vultures, drawing on the energy of the management team.
10. Less competition when new. New funds target market niches identifies as hot new markets ripe for investors interested in new fund offerings. As money comes in and returns improve, competition increases. Size limits pickings. Deals get scarcer. And the new fund “edge” vanishes.

Most of the superior performance takes place in the first 12-18 months after launch. Generally, after 18 months these factors begin vaporizing and the fund’s performance will melt into its peer group average. So if you buy, ride them up for 12-18 months, then dump them for a seasoned fund. Bottom line: If you insist on buying a new fund, figure on dumping it within a year-and-a-half, or minimize your risks by betting on new no-load funds backed by established fund families with experienced managers and strong research staffs. Otherwise, your money could self-destruct like Mr. Phelps Mission Impossible tapes.

FirstPubDate: Apr’01