When "Best Ideas" Go Bad

A plaintive posting on our conversation boards caught my eye a while back. Why, the writer quavered, did his "best ideas" fund--ostensibly an offering that combines a fund shop's best and brightest--continually lag its benchmark, its assigned category and, in some cases, its like-minded siblings?

This particular writer was referring to the miserable performance of INVESCO Endeavor , which has suffered a nasty drop of 22.5% since its launch in late October 1998. But Endeavor isn't the only "best idea" fund in trouble: For investors chronically in search of the next best thing, these offerings have been some of the most alluring--and damaging--initiatives mounted by the mutual-fund industry over the past several years.

The logic behind this concept seems airtight. Fund shops give the company talent--either analysts or portfolio managers or both--the freedom to buy stocks in which they have the most confidence, unconstrained by style-box considerations. The majority of these funds are able to invest across the market-cap spectrum and most of them can invest up to a fourth of their assets abroad. Some can invest in options and futures and carry hefty cash balances; almost all are free to run extremely concentrated portfolios.

These offerings don't employ exactly the same strategy, of course. Funds from large, sell-side firms, for example, often field portfolios culled from their well-publicized industry lists. Morgan Stanley Competitive Edge Best Ideas , for example, buys 40 stocks from the company's Competitive Edge research compilation, which generally includes about 250 firms. Likewise, Brinson Strategy  (formerly called PaineWebber Strategy) purchases approximately 50 companies from UBS Warburg's Highlighted Stocks list to build its portfolio.

Meanwhile, smaller shops, such as MFS, tout their meeting-of-the-minds approach, conjuring up images of late-night brainstorming sessions between dedicated analysts and portfolio managers. Other companies, such as Berger, offer investors the family's best efforts: stocks culled from their siblings' portfolios. Like their rivals from the investment-banking world, these fund shops often present investors with highly concentrated portfolios. Berger Select , for example, owns just 22 stocks.

Whatever the style, these funds haven't had trouble raising money. When Brinson Strategy launched, it pulled in $2.1 billion in its subscription period, immediately making it one of the larger offerings in the large-growth category. Lower-than-average expenses often add to the appeal of these funds.

Sounds great, but "best ideas" funds have been anything but a slam dunk. In fact, most of these funds have been mediocre performers at best. More than half have lost ground since inception.

"Best Ideas" Funds Trail Their Categories
	12-Month Return ( % )	3-Year Return ( % )	5-Year Return ( % )	10-Year Return ( % )	Fund Inception Date
Mid-Cap Growth	-45.64	6.53	4.28	9.57
Berger Select	-65.47	-6.29	N/A	N/A	12-1997
Morgan Stanley CmpEdgBstId A	-37.49	-3.33	N/A	N/A	2-1998
Large Growth	-43.79	-0.14	5.82	9.57
AIM Select Equity A	-48.27	5.15	7.10	9.08	12-1967
Brinson Strategy A	-48.22	N/A	N/A	N/A	11-1999
INVESCO Endeavor C	-73.09	N/A	N/A	N/A	2-2000
Large Blend	-27.40	1.73	7.94	10.94
AXP Research Opportunities A	-33.35	-0.01	5.33	N/A	8-1996
Goldman Sachs Res Sel A	-40.87	N/A	N/A	N/A	6-2000
MFS Research A (MFRFX)	-38.83	0.18	5.10	12.05	10-1971
T. Rowe Price Capital Opport (PRCOX)	-25.41	1.05	2.46	N/A	11-1994
All data including annualized returns through 9-30-01.

Obviously, many of these funds have suffered recently for their decided growth tilts--not to mention their poorly timed launches. With a concentrated portfolio full of fast-growing giants such as Cisco (CSCO), for example, the Brinson fund has dropped 55% since its December 1999 launch. Goldman Sachs Research Select , a similarly concentrated offering, has lost more than 37% since its July 2000 inception.

But many of these funds looked ugly before the market turned south and growth fell from grace. Part of the problem is their lack of discipline. AXP Research Opportunities Fund , for example, has often suffered relative to its siblings for its sizeable sector bets, even during growth rallies. What's more, Morningstar recently completed a study that showed funds such as Berger Select, which often depend on other funds' top picks, are taking real risks. According to the September 2001 issue of Morningstar FundInvestor, the top-10 holdings of domestic-equity funds beat the rest of their portfolios less than half the time. (To find out more about Morningstar FundInvestor, please click here.) Finally--and most important--these "best ideas" funds suffer from revolving-door syndrome; an ever-changing lineup of analysts can make for volatility. What's worse, analyst turnover isn't often public record, so it's impossible to pin bad (or good) performance on any given set of individuals.

There are exceptions, of course. Probably the best of the breed is MFS Research (MFRFX), overseen by Mike Lawless. Lawless bases the portfolio on the work of the shop's 26 industry analysts, most of whom are headed for portfolio-management positions eventually, but who have to work their way through MFS's strict training system. Like other offerings in this style, the fund's growth tilt and sector bets have hurt its returns over the past year or so. What's more, it's one of the more-volatile large-blend offerings. Still, over time, these wild swings in performance have generally been more good than bad, so the fund has managed to eke out a place in the top half of the category under Lawless's direction.

If that sounds like faint praise, it is. To put it plainly, we're having a tough time accepting the alleged superiority of the "best ideas" concept. Generally, these offerings have been a perfect--and money-losing--example of how theory and practice don't always mix. To paraphrase an old saw: With "best ideas" like these, who needs a bad one?