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Hottest funds can turn cold in a flash

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NEW YORK -- To get an idea of how suddenly a hot category of mutual funds can turn cold, take a look at the recent performance of financial services funds.

Until last summer, these funds specializing in bank, insurance, mortgage and investment-firm stocks had been one of the standout groups of the 1990s. Their performance results often came in better than even the celebrated technology funds.But all that changed abruptly in the third quarter of last year, as a default by Russia and other international debt and currency problems stirred fears of a worldwide financial crisis.

In August alone, the average financial-services fund tumbled 21 percent, according to the Morningstar Mutual Funds research service.

As the dust settled at the end of 1998, Morningstar's average of 55 financial services funds, with aggregate assets of about $20 billion, managed to post a 6.43 percent gain for the year -- about 22 percentage points short of the Standard & Poor's 500-stock composite index's rise. Technology funds, by contrast, jumped more than 51 percent.

That 6.43 percent return marked a big comedown from gains of 44 percent in 1997, 27 percent in 1996, and 40 percent in 1995. In each of those years, financial funds outgained technology funds.

In fact, as of mid-January, financial funds still showed annualized returns of better than 20 percent for the past five and 10 years, less than a percentage point shy of technology funds' results for the same periods.

Over the first few weeks of 1999, however, the group once again drifted lower, as problems in Brazil kept investors uneasy about the international financial outlook.

Despite all the new worries, the main story behind financial funds' decade-long popularity hasn't changed much. An aging generation of baby boomers in this country is expected to generate big demand for financial services for years to come.

A strong economy keeps pumping money through the U.S. financial system, while nearly dormant inflation allows for relatively low interest rates. A steady pace of mergers in the financial industries, meanwhile, creates additional profit opportunities in the stocks of the companies involved.

International worries have clearly thrown cold water on some of the highest hopes investors had built up. But some stubborn optimists say the setback may not go too much further.

As Jeffrey Warantz at the Wall Street firm of Salomon Smith Barney put it in a recent report, "The performance of the sector has been hurt severely by the global financial crisis and its reverberations. It appears that the negative reaction to this crisis may have been a bit excessive.

"Underlying fundamentals remain intact. The U.S. economy is still strong, interest rates remain low, and the monetary environment remains positive. These conditions typically bode well for financial stocks. Finally, the dramatic reduction of earnings estimates within the sector as a result of the panic sets the stage for what we believe will be a large number of positive surprises in the coming months.

"We believe the damage has been done and the worst is now behind the financial sector. Earnings estimates are now improving, economic fundamentals remain attractive, and the sector is inexpensive."

But whatever they do next, financial-services funds have clearly shown what can befall investors in funds that concentrate on a single industry or sector of the economy. It's a story worth heeding for fans of other standout sectors, like Internet-focused technology funds and health-care funds.

Even if a convincing story supports enthusiasm for such a group, an investment in a fund of this type can be subject to wrenching volatility.

Observed the Value Line Mutual Fund Survey in its most recent look at financial-services funds, "On the bright side, the downturn may have resulted in an attractive entry point for prospective investors.

"All investors, however, should realize that the industry's highly cyclical nature makes it best suited for risk-tolerant investors able to stomach any upturns and downturns of the domestic economy."