A classical example of chasing the hot dot is the Munder Net Net Fund. This high-flying mutual fund exemplifies the disaster that can happen to your savings if you get caught up in the euphoria of a hot fund, which eventually becomes a black hole that sucks up your money.
In August 1996, the investment firm of Munder Capital Management in Birmingham, Michigan, decided to create a unique and unusual sector fund. The fund was to invest in the companies that were in the Internet business. Investments included Internet service providers like AOL, Internet retailers such as Amazon.com, browser software companies such as Netscape, and companies that sold modems and equipment to hook up to the Internet.
The headquarters for Munder Capital Management was about five miles from the brokerage office where I worked at in the 1990s. the brokers in my office had several client relationships with Munder at the time and we typically obtained information on new fund offerings before they became public knowledge. When we learned that Munder was going to offer a mutual fund that invested exclusively in Internet-related stocks, we had a good laugh. How much more ridiculous could the prices of Internet stocks get? I felt they were clearly overvalued. That was in late 1996.
After respectable first-year results, over the next two years the performance of the Munder Net Net Fund blew the doors off of every mutual fund in the country. The fund earned a 98% return in 1998 and 176% in 1999. This spectacular show grabbled the hearts, minds, and wallets of mutual fund investors far and wide. By late 1999, tens of millions of dollars per day were pouring into the Munder Net Net Fund. Assets exploded from just under $300 million at the beginning of 1999 to over $10 billion by March 2000.
Are You chasing the Hot Dot?
The discrepancy between investors’ investments in the Munder Net Net fund and the subsequent performance of the fund acn be seen in the illustration diagram below. As luck would have it, billions of dollars of newly invested capital vanished between March 2000 and the end of that year as the fund tumbled 54% in value. The massacre continued though 2001 with a 48% drop and billions more were lost. In 2002, the loss was 45%. Over the three-year period, the Munder Net Net Fund lost nearly 90% of its starting value and billions of dollars in investors’ money. Some people were lucky: they sold early and salvaged a portion of their invested capital. Others hoped for a rebound: they stayed in for the full onslaught, as no rebound ever materialized.
A casual observer might conclude that the Munder Fund was a dismal failure from its beginnings in September 1996 to the end of 2002 because of the amount of money that was lost in the fund. But, that is not the way the mutual fund industry sees it. The method of performance measurement used by mutual fund companies is quite different from what first meets the eye.
According to the Morningstar principia database, the annualized return of the Munder Net Net fund class A share since inception was positive 2.15% annually, which was about the same as the typical Technology Fund, but lower than the 6.4% compounded return for the S&P 500 during the same period. As a result, Munder might say the fund “made money” since inception, which is not bad given the environment for technology companies. If you were an investor in the fund, would you feel the same way?
The Munder Net Net Fund reported return numbers are a classic example of performance reporting shenanigans. The standard method of performance measurement used by the investment industry is called time-weighted returns (TWR). Fund performance is calculated by placing a hypothetical $100 in that fund and then tracking the performance of that $100 over the years. Actual deposit and withdrawals in the mutual fund have no bearing on the reported performance number; only the original $100 matters. For example, if $10,000 were invested in the Munder Net Net Fund on October 1, 1996, it would have grown to $115,600 by February 2000. That is a total return of 1006% and an annualized return of 98.7%. But by the end of 2002, the original $10,000 investment was worth only $11,786, a total gain of only $1,786. However, a $10,000 investment in December 2000 would be worth only $1,314, a loss of $8,686.
When calculating total return since inception, Munder is not concerned with the investor who lost $8,686. What is important is only the hypothetical investor who made $1,786 since inception. The fact that billions of dollars were invested in the Munder Net Net fund near the peak of the market and subsequently lost is irrelevant.
The problem with the TWR method is that it does not tell us how much money was made or lost in the fund over the period. It tells us only how much the return would have been if someone had held the fund for the entire period being measured – which is relatively useless in this particular case, because the amount of money in the fund at the start of 1997 was insignificant.
Munder does not have to disclose actual money gain and money loses in a fund. Nor does it have to disclose important items like risk measurements. Like all mutual fund firms, Munder can advertise fund performance over any period it wished, as long as the time-weighted return is calculated correctly. Without the help of independent services like Morningstar to track fund performance and analytics, investors would be totally in the dark as to which funds made investors money and which ones did not.
The Three Axes of Style Chasing
There are three basic ways people chase returns. First, there are shifts between growth and value stocks, second, there are shifts between large and small stocks; and third; there are shifts between U.S. and foreign stocks.
The Growth and Value Axis
The growth stock boom of the late 1990s and bust of the early 2000s is still fresh on minds of investors because it occurred so recently. In addition, a lot of new investors got hurt in the cycle because there were tens of millions of new people in the market at the time. However, what happened with growth stocks during the period was not unique of even unusual. There have several growth stock booms and busts over the years.