11 Lessons From a Losing Fund

Editor's note: The following was excerpted with permission from a Kiplinger.com article by Steven T. Goldberg.

Garret Van Wagoner is departing the stock picking business, saying that his firm plans to hire outside managers to run all but one of its funds. The other will be a fund of funds run by Van Wagoner.

Before we bid adieu to Van Wagoner, though, we can glean some valuable lessons from him about how not to invest, both in stocks and in mutual funds:

Lesson one
Compound losses kill you. Since its inception at the end of 1995, Van Wagoner Emerging Growth lost an annualized 7.8 percent. (Several smaller funds didn't do much better.) Over that period, Standard & Poor's 500-stock index returned 9.3% annualized, or a cumulative 191 percent — it nearly tripled, in other words.

Now, Van Wagoner's annual compounded loss of 7.8 percent may not sound that terrible, but it comes to a cumulative loss of 62.3 percent. And that doesn't include the fund's loss of 25% this year through February 25.

Lesson two
Don't overreact to one big year. Those returns came despite some magnificent years. In 1999, Emerging Growth fund returned 291 percent — better than any other fund in that fevered bull market year.

Resist the urge to climb aboard the year's number-one fund. The odds are ridiculously high that it won't stay in that lofty perch. What's more, given the kind of volatility it almost always takes to finish at the top, the odds are strong that one year's sizzler will suffer huge declines at some point.

Lesson three
Beware of rotten returns over a period as long as a year when they're way out of sync with the rest of the market. In 2001, Van Wagoner's fund lost 60 percent; the next year, it lost 65 percent. Indeed, the fund plunged 92 percent in the 2000-2002 bear market, meaning that for every dollar you'd invested at the peak, you'd have been left with just 8 cents by the time stocks finally bottomed.

Only two regular stock funds still in business did worse during the bear market: Berkshire Focus, which lost 94 percent and Jacob Internet, which fell 95 percent.

What lured the unwary into Van Wagoner Emerging Growth was its start: Up 27 percent in 1996, down 20 percent in 1997 and up 8 percent in 1998. After fund gained 291 percent in 1999, who could be faulted for climbing aboard? In hindsight, 1997 was the tipoff. The S&P 500 returned 33 percent that year; NASDAQ was up 22 percent.

Lesson four
Pay attention to volatility. Before you invest in such a fund, you need to learn why the returns deviated so wildly. In Van Wagoner's case, it was because he specialized in small, risky tech companies — some of them not publicly traded — with little or no earnings.

Instead of dwelling on Van Wagoner's returns, investors would have been better served by focusing on his funds' volatility. You can look up standard deviation, an excellent proxy for volatility, at Morningstar.com. The figure measures how much a fund's returns bounce around from month-to-month or year-to-year.

The actual number isn't as important as how it compares to that of other funds or of relevant benchmarks. The ten-year standard deviation for Van Wagoner Emerging Growth is 50, among the highest of any fund. By contrast, the S&P 500 has a ten-year standard deviation of 15.

Standard deviation is a wonderful predictor of how a fund will perform in a bear market. The higher a fund's standard deviation, the bigger the potential it has to implode.

Lesson five
Beware of high turnover. Van Wagoner's semi-annual reports were dotted with other danger signals. The man loved to trade. In 1998, his turnover was 668 percent. That meant that, on average, he was holding stocks less than ten days each. Most years, turnover was only about 300 percent — still a high number.

(Of course, there are exceptions to all rules. Ken Heebner, manager of CGM Focus and other funds, has a terrific long-term record. Yet his funds are extremely volatile and he trades a ton. What's more, his funds occasionally finish at the top of the performance charts sometimes finish near the bottom. My conclusion: Heebner is an anomaly. In general, you want to stay away from funds with those kinds of characteristics.)

Lesson six
Managers who charge high fees are usually more interested in their profits than yours. The Van Wagoner funds' expenses were another tipoff. Emerging Growth didn't always charge 3.7 percent in annual expenses, as it does now that assets have fallen to $18 million. But the fund typically charged almost 2% annually.

Lessons seven and eight
Don't speculate, and, if you do, set a firm stop loss. Tech mania was in full throttle in 1999 and early 2000. The problem for those who resisted its charms was that it kept going and going and going. Almost every day, tech stocks would soar, and you felt like a chump sitting in almost anything else because it was going nowhere.

Eventually, even some of the biggest tech skeptics, including yours truly, made a deal with ourselves: Let's stick a little money into Van Wagoner Emerging Growth even though we know its stocks are wildly overvalued -- and, as soon as the market starts to fall, we'll bail.

The problem is that almost no one had the sense to bail soon enough to avoid big losses. Almost everyone held on too long, hoping to get even.

Lesson nine
Favor a manager who employs a consistent discipline to size up stocks. Van Wagoner's returns were terrific during the tech bubble, but he always had one problem: He never had an investment discipline to back up his decisions.

Instead, he bought companies that seemed like they had good ideas-not necessarily those turning profits or increasing sales, much less selling at reasonable valuations.

If your value manager buys Google, it's usually time to sell.

Lesson ten
Avoid doing business with fund managers who've gotten into hot water with the SEC. Van Wagoner ran afoul of the Securities & Exchange Commission. In 2004, he and his firm paid $800,000 after accusations he had misspriced securities and defrauded shareholders. (Neither Van Wagoner nor his company admitted or denied guilt.)

Lesson eleven
Mutual funds and mutual fund families that go bad rarely come back. Look elsewhere. Until recently, Van Wagoner kept trying to revive his career. But the best he could muster was a good quarter here and there.

Under the new arrangement, Van Wagoner will remain the funds' adviser. His firm has hired Insight Capital Management, piloted by Jim Collins, to manage three of the funds, including Emerging Growth, and Husic Capital Management, headed by Frank Husic, to manage two others.

Steven T. Goldberg writes the Valued Added column for Kiplinger.com and is a partner in Tweddell Goldberg Investment Management (www.tginvesting.com), which provides investment advice to individuals and manages their money, chiefly with mutual funds. The firm also sets up and monitors 401(k) plans for businesses.Goldberg was formerly the senior fund writer for Kiplinger's Personal Finance magazine and is the author of the book But Which Mutual Funds? How to Pick the Right Ones to Achieve Your Financial Dreams. He lives in Silver Spring, Md., a suburb of Washington, D.C.