How 2003's Hottest Funds Have Fared in 2004

Thinking about buying one of those hot energy funds, or maybe a real estate fund that has put up big numbers this year? Before you do, take a look at how 2003's biggest winners have fared.

Last year, there were 14 funds that managed to put up returns in excess of 100%, so I thought I'd take a look to see how things were going. Needless to say, this was a high-risk bunch. The theme running through the list was tech and leverage. After all, you're not often going to put up triple-digit returns with a cautious, diversified strategy.

Five leveraged index funds made the list. Two more were Internet funds. We also had a couple that didn't fit into those groups. Ishares MSCI Brazil (Free) Index  (EWZ) and Eaton Vance Greater India  (ETGIX) put up huge returns as those countries' markets took off.

How would you have done if you'd hopped on the trend and bought one of these funds? In this case, chasing the crowd would have yielded a lemming-style conclusion. On average, last year's big winners are down 4% through October, compared with a 3% gain for the S&P 500. The top two funds are particularly impressive: Apex Mid Cap Growth  and ProFunds UltraSemiconductor (SMPIX) have followed triple-digit gains with double-digit losses. About the only one to have another good year was the closed  Schneider Small Cap Value , which is up 18% this year.

There are a couple of clear lessons here. The only thing that you can be certain of when you look at a list of short-term winners is that they took big risks to get there and that they are probably invested in an asset class that's due to cool off.

Of course, most investors have enough sense not to pile into a leveraged semiconductor fund, but there are some broader lessons that apply here. Now that small caps have enjoyed a tremendous five-year run of outperformance, I'm starting to hear investors rationalize why this will continue for many years to come, just as I heard in 1999 why tech would go on forever. This time around, I'm told that the small-cap effect and trailing mutual fund returns prove that small-cap stocks are superior investments to large caps.

It's true that small caps have a modest edge over the long term. However, that doesn't mean that history will repeat. Even if it does, there have been plenty of periods when large caps whipped small caps over 10- and 15-year periods, so there's no guarantee that small caps will win out over your investment horizon. That goes double when the starting date is set after a huge five-year run.

If you're throwing more and more money at small caps today, you're doing a more subtle version of the lemming's leap. There's now a growing chorus of small-value managers who are warning that small-value stocks are much less attractive than they were in years past. Preston Athey of  T. Rowe Price Small-Cap Value (PRSVX), for example, is sounding the alarm.

As you think about how you'll rebalance your portfolio in the new year, be sure to consider whether you have an oversized bet on small caps. It might be time for the much-abused megacap world to rally.

Should You Invest in a Car Loan?
On a completely different topic, I was a little stunned to see personal finance guru Suze Orman pitching Pontiac loans in TV commercials. In general, it's a good idea to avoid going into debt over a depreciating asset. Homes and education are worthwhile for borrowing because they're appreciating assets, whereas cars are not. Sure, sometimes you need to take out a car loan because your old car needs expensive repairs. But if you can make your car last a while longer, it's a good idea to try to save up so that you can pay in cash.

There's a great book on the subject by Vanguard's Andrew Clarke called Wealth of Experience: Real Investors on What Works and What Doesn't. The book is based on a survey of successful individual investors who explain how they did it. One of the most common traits was that they had the discipline to save. If you've got that, everything else is pretty easy.

But don't take my word about the value of avoiding debt. Take Suze's. About a month ago, the Chicago Tribune asked some financial experts what their biggest mistake was:

"Suze Orman says the stupidest thing she's ever done was leasing a gold-colored BMW 735i for $800 a month in 1987 (that's about $1,300 in today's dollars). 'I did it to impress the person I was in a relationship with,' said Orman, who dispenses financial advice through books, columns and television. 'I thought I was brilliant. I didn't have to come up with the money to buy it, and everybody would think I could afford it.'…

It took another three years to dig herself out, and these days Orman doesn't buy anything if she can't write a check for it. 'If I have to finance it, I can't afford it,' she said."

By the way, Chuck Jaffe isn't a big fan of Orman's endorsement deal, either.Click hereto see his column on the subject.