The Tech Wreck

pon reflection, the transition into Y2K went rather smoothly. That is, if we ignore the tech wreck of 2000. The basic lesson from the tech wreck of 2000-2002 is a lesson that many refuse to learn only once: Investors who chase returns are often disappointed. A corollary lesson may be that mutual fund companies which flood the market with a certain type of portfolio may be late in the cycle as well.

Case in point: One hundred U.S. technology-based equity funds were launched between January 1997 and December 2002. Just over half of the total (51 funds) were christened in calendar year 2000. Figuring out why the year 2000 was a bumper crop for tech funds is not complicated. The average tech fund produced a return of nearly 60% in 1998 and over 140% in 1999. Thus, fund companies - looking through rose-colored silicon wafers - saturated the market with tech portfolios.

In December 1998 there were a total of 48 technology equity funds (as defined by the Morningstar guidelines in their Principia Pro software). By the end of 2000 there were 118 tech funds - an increase of 146% (see Figure 1). This bulge in tech portfolios took place between June 1999 and Dec 2000. In the short space of 19 months, 70 new equity funds with a heavy weighting in technology were launched. These totals only consider distinct, surviving portfolios as of April 2003.

On a technical note, data in Figures 1 and 2 include only distinct, domestic (U.S.) technology funds. The term "distinct" indicates that among multiple share class funds only the primary share class was included in this analysis. Number of funds and net asset totals would be higher and returns would be different if all share classes were counted. The rationale for only including distinct funds is to avoid the problem of over weighting the returns of a single portfolio, which in some cases may have three or four different share classes with identical holdings.

As shown in Figure 1, even though the number of tech funds surged in 2000, tech fund assets swelled in 1999. From year-end 1998 to year-end 1999 tech fund assets increased from $16.6 to $36.3 billion - an increase of 119%. Ironically, just as returns in the tech sector began to slip in Q2 2000, the surge of new tech fund offerings began hitting the market. Total tech fund assets showed only a slight increase of less than 1% by the end of 2000 due to falling net asset values (which shrinks fund assets) and cash flowing in and out of tech funds. By year-end 2001 tech fund assets had declined by over 16% and by end of year 2002 tech fund assets had fallen another 30%. Thus, in the span of 24 months (from December 2000 to December 2002) tech fund assets declined by roughly 41%.

One benchmark index for tech funds is the Pacific Stock Exchange Tech 100. The annual returns from 1997-2002 for the PSE 100 Index are shown in Figure 2. Over that six-year period the PSE 100 Index had an average annual return of 11.2% and a standard deviation of return of over 56%. The average return of tech funds launched after January 1996 (assuring at least one complete year of return data by December 1997) was 1.54%, with a standard deviation of return of over 72%. When weighting the funds by their respective percentage of total tech fund assets, the six-year average annual return improved slightly to 2.9%, but the standard deviation of return increased to 83%. In all but 1997, tech mutual funds had higher highs and lower lows relative to the returns of the PSE 100 Index during this particular six-year period.

The performance of tech-based mutual fund portfolios relative to the PSE 100 Index suggests that many tech funds hold different tech stocks, or some of the same stocks but in different proportions. During the late 1990s, tech funds that heavily weighted certain "outperforming" firms (e.g. Sun Microsystems, Cisco, EMC, Qualcomm, etc.) outperformed the PSE 100 Index. For example, in mid-1999, Qualcomm represented 2.74% of net assets in the PSE 100 Tech Index, but in one tech mutual fund the weighting of Qualcomm was as high as 9.0% of net assets. Sun Microsystems was 1.32% of the PSE 100, but as high as 4.9% of net assets among one tech fund. Cisco was 1.23% of the PSE 100 assets, but over 10% of another tech fund's assets. EMC was 1.05% of the PSE 100, but nearly 10% of one tech portfolio in mid-1999. Thus, many tech funds were benefited by their large percentage holdings in certain tech stocks during the late 1990s, but were then punished by the same large positions in such firms when many of them tumbled hard as the tech sector melted down.

Figure 2 also contains a mathematical attempt to simulate the return achieved by "average tech investors" over the six-year period from 1997 to 2002. Only funds launched after January 1996 were considered in this analysis in an attempt to isolate the returns achieved by the surge of tech funds pumped into the market in the late 1990's by over zealous mutual fund companies. This estimate was achieved by multiplying each annual asset-weighted return of tech funds by the cumulative percentage of post-1996 tech funds. In 1997, this meant that the 16.0% asset weighted return for tech funds was multiplied by 11%. Recall that there were 100 tech funds introduced between 1997 and 2002. Eleven of those 100 were launched in 1997; hence that is source of the 11% figure.

This estimation procedure yields an annualized return of -12.2% for "average" tech fund investors who invested in tech funds between 1997 and 2002. When put into dollar terms, average tech fund investors turned a $10,000 investment at the start of 1997 into just under $4,600 by the end of 2002. Of course, if tech investors got in during the early days of 1997 and got out in late 1999 or early 2000, the tech ride was rather gratifying. However, as the timing of many mutual fund companies was clearly less than optimal (as evidenced by a surge of tech funds just as the tech bubble was bursting) it seems reasonable to assume that many individual investors suffered similar poor timing.

Finally, another method of representing the return of the average tech investor is shown in Figure 3. The left vertical axis of Figure 3 represents the cumulative number of tech fund launched on or after January 1997. On the right-hand vertical axis is the monthly return of the PSE 100 Tech Index. The striking image offered by this figure is that most of the large positive returns of the Tech 100 index were achieved when there were relatively few funds. After the number of funds increases dramatically during 2000, the pattern of the histograms (or bars) changes dramatically -- with more going down than up. In other words, the vast majority of technology-based funds arrived just in time to experience the worst of times. Sort of like the circus tent filling up with people just as the best acts are concluding…and then a fire breaks out.

Investors are constantly counseled to not chase returns. Ironically, mutual fund companies are often the ones offering that advice. Mutual fund companies that were pumping out tech funds in the year 2000 should consider their own advice.

Figure 1. The Tech Stats

Year	Number of Tech Funds Launched*	Cumulative Number of Tech Funds*	Total Domestic Tech Fund Assets ($ million)
			New Assets into New Tech Funds	Change in Assets in Existing Funds	Cumulative Total Tech Fund Assets
Pre-1997	29	29	--	--	15,389
1997	11	40	304	--	15,693
1998	8	48	556	440	16,689
1999	19	67	11,400	8,187	36,276
2000	51	118	4,795	-4,523	36,548
2001	10	128	5,302	-11,244	30,606
2002	1	129	120	-9,320

* Based upon surviving funds as of April, 2003

Figure 2. Tech Funds Launched After January 1996

Figure 3. Losses of the Many