How can I tell if a mutual fund is inflated?

Question

To reach a prudent asset allocation, I need to add a small cap mutual fund to my portfolio. I'm a little concerned that I am "buying high" because all the small cap funds I'm considering (below) have had 20%+ returns in the last 1 year. I would like to "buy low, sell high" and not sure how to apply it here. I don't consider this market timing because I plan on buying and holding and prefer to buy when the fund is not inflated i.e. over-priced or over-valued by the market. Any ideas here on major indicators to measure if a fund is over-valued?

Symbol     Fund Name                    1 Wk        13 Wk       YTD         1 Yr        3 Yr        5 Yr        10 Yr   
PENNX       Royce Fd:PA Mut;Inv          2.41%       13.64%      2.23%       22.86%      6.54%       4.98%       10.30% 
STSCX       Stratton:Small-Cap Val       2.62%       14.89%      2.64%       21.29%      4.81%       3.17%       10.12% 
NAESX       Vanguard Sm-Cp Idx;Inv       2.34%       14.98%      3.14%       27.15%      7.23%       5.09%       7.50%  
RYLPX       Royce Fd:Low-Prcd;Svc        2.67%       15.15%      1.15%       27.14%      11.02%      8.62%       11.14%

Answer 1

The NASDAQ composite index was up just over 25% in 2010. So the returns you show are in line. Chasing returns, by going after last year's winners, or bottom feeding by chasing last year's losers, are both bad ideas. I recommend staying with an asset allocation and not market timing. How would this strategy (which I'm not 100% clear on) have served you in the 80's and 90's, when the market was overpriced for nearly two decades?

Answer 2

I understand your concern with small-caps being "high" right now. They have often appeared "high" in the past, but have continued higher and higher. There's no reliable way to judge "high".

I recommend stepping in with dollar cost averaging, rather than waiting for the funds to get low. This will partially protect you from buyers remorse, should the funds drop soon.

Also, the beneficial effects of dollar cost averaging are more visible with more volatile instruments like small-cap funds.

Answer 3

Well, you used the word "prudent" to describe your desired asset allocation, which you have determined should include some small-cap stocks. That indicates that you've thought about it carefully and think that this is what you want to do, right?

I was going to recommend P/E ratio, but the NASDAQ doesn't publish that piece of information as far as I know. If you can piece together the earnings information for the big components, then you could estimate that, I suppose.

The sources I follow are doing the opposite of what you're about to do, but I'm but one person with but one opinion. :)

Answer 4

Any ideas here on major indicators to measure if a fund is over-valued?

Something to consider with the funds you are considering is how pure of the style you seek are they? If some of the small-cap funds have had a good run and held onto those winners, they may become mid-cap stocks instead of being small-cap and thus it isn't what you want. I'd be more tempted to check the portfolios and strategy to see how do they plan on staying pure to being a small-cap fund rather than getting too much into mid-cap or other categories.