Sector funds ought to come with a warning label, writes Joanathan Clements in today’s Wall Street Journal.

“Whether it is defective toys, Firestone tires or child-safety seats, potentially hazardous products are recalled all the time. But things work a little differently in the mutual-fund business.”

“Exhibit A: sector funds. These are one of the financial world’s most dangerous products. The fund industry’s response? They are pumping out the darn things faster than ever.”

“That is bad news for investors. It has become an all-too-predictable cycle: A market segment turns hot, sector funds are rushed to market, investors pile in, the sector collapses and shareholders bail out, usually licking their wounds.”

” ‘When fund companies are launching a lot of new funds in a particular sector, you should approach the funds with trepidation,’ warns Dan Culloton, an analyst with Chicago fund researchers Morningstar Inc. ‘History shows that fund companies often introduce new funds at the worst possible time. It’s hard to say whether the fund companies are caught up in the excitement or whether they’re cynically saying that this will bring in the fees.’ “

“Whatever the motivation, mutual-fund companies aren’t doing their shareholders any favors. For proof, look no further than the recent technology debacle. Technology-sector funds posted spectacular gains, climbing an average 53.9% during 1998, 136.6% during 1999 and another 19.1% during the first three months of 2000.”

“But it isn’t clear how much money was made, because so many shareholders were late to the party. At the market’s peak in March 2000, technology funds had $168.6 billion in assets. But much of that money poured in during the tech boom’s final months. Six months before the peak, tech-fund assets were just $58.8 billion, according to Morningstar.”

“How did that $168.6 billion of shareholder money fare? No doubt a few investors bailed out early, booking handsome profits. But many investors hung on as tech funds lost a breathtaking 49.9% during the 15 months through June 30.”

“Unfortunately, there is nothing new about this cycle of euphoria and despair. One of the earliest sector-fund disasters involved Fidelity Select Technology Portfolio. The fund soared 162.1% for the year through June 30, 1983, along the way attracting $670 million in assets and earning its manager a spot on Money magazine’s cover. But from there, it was all downhill, as the fund fell 24.7% during the next 12 months.”

“Eight years later, health-care and biotechnology funds got their turn. The funds gained an average 63.8% for 1991 and assets almost quadrupled. Sure enough, performance soon collapsed, with the funds trailing the market average for 1992 and 1993.”