Should You Buy This Hot Fund Now?

With many stock markets around the world down by double-digit percentages, anyone who's bucked the trend and made money in stocks clearly has something going right. Yet even if a particular money manager has done well lately, that doesn't mean you should count on a bright future.

Recently, I read about a select list of funds that had positive returns both over the past 12 months and so far in 2008. As you'd expect in a bear market, that list was short -- fewer than 20 funds out of the thousands of U.S. stock funds available to investors. The article highlighted one of the outperforming managers, Nancy Tooke of the Eaton Vance Small-Cap Growth Fund (ETEGX).

Now, it's always interesting to see what strategies are working in a tough market. The problem, however, lies in suggesting that a short-term win necessarily bodes well for a fund's long-term prospects.

Downsides of hot funds
Unfortunately, short-term high flyers have historically tended to fall back to earth soon thereafter. A host of technology and Internet-related mutual funds took advantage of huge gains in the Nasdaq during the late 1990s to post triple-digit gains. Yet when the hot sector yielded to the bear market of 2000-2002, funds like Jacob Internet (JAMFX) nearly imploded, as holdings like Akamai Technologies (Nasdaq: AKAM  ) and Priceline.com (Nasdaq: PCLN  ) suffered staggering drops.

More recently, similar patterns have emerged in other sectors. Value funds showed strong performance for much of the past decade. Yet as financial stocks like Citigroup (NYSE: C  ) and Lehman Brothers (NYSE: LEH  ) have buckled under the weight of the credit crunch, even renowned value managers like Bill Miller and Bill Nygren have seen lackluster returns. And with the recent pullback in oil and other commodities, many hot funds investing in those sectors have started to falter.

Too early to tell
The trouble with focusing on short-term performance is that it doesn't give you enough information to make a strong conclusion about a fund's future. With the Eaton Vance fund, there's no denying that Tooke has made smart, well-timed investments in companies like Petrohawk Energy (NYSE: HK  ) , Big Lots (NYSE: BIG  ) , and Kansas City Southern (NYSE: KSU  ) . And there's something to be said for the fact that although the fund lagged its peers from 2001 to 2005, its string of outperformance began at the same time Tooke started managing the fund.

For prospective investors, though, the Eaton Vance offering has a couple big shortcomings:

  • Cover charge. With many funds, before you can play, you have to pay. As with many Eaton Vance funds, Small-Cap Growth charges a sales load of up to 5.75% on new investors. If you'd bought the fund at the beginning of the year, the fund's 5.4% year-to-date return wouldn't be worth as much to you: You'd still be down on the year.
  • High expenses. The fund also charges a fairly hefty annual expense ratio of 1.48%. Even with a healthy 10-year average return of 11.7%, the fund's costs are siphoning off more than 10% of that return each and every year -- a draw that will take on even more significance if the fund's performance slips back to less appealing levels.

The lesson here isn't that it's impossible for fund managers to beat the market. Over time, the cream of the crop rises to the top, consistently demonstrating an ability to adapt to changing market conditions and produce good returns for investors. If Tooke stays on top in the years to come, she may establish her place among that elite crowd. But for now, remaining skeptical after just two years of impressive returns may help you avoid making a big mistake.

For more on finding the best mutual funds, read about:

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Fool contributor Dan Caplinger mostly sticks with index funds. He doesn't own shares of the funds and stocks mentioned in this article. Akamai is a Motley Fool Rule Breakers pick. Priceline.com is a Motley Fool Stock Advisor recommendation. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy will be there for you tomorrow.


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