(MONEY Magazine) – If you like to scan the mutual fund performance tables in your newspaper, you've probably noticed something intriguing: Brand-new mutual funds are posting stratospheric returns lately. An amazing 16 of this year's top 20 performing portfolios are less than a year old, according to Lipper Analytical Services. A few examples of year-to-date performance (through May 30):

--T. Rowe Price Health Sciences, launched Dec. 31, 1995: up 24.9% --Janus Olympus, launched Dec. 29, 1995: up 28.8% --PBHG Core Growth, launched Jan. 2, 1996: up 40.8% --Van Wagoner Emerging Growth, launched Dec. 31, 1995: up 56.2% --Dreyfus Aggressive Growth, launched Sept. 29, 1995: up 66.4%

All this while Standard & Poor's 500-stock index has risen "only" 9.1%.

MONEY has long advised that you should buy a fund only if it has built up a track record of solid returns over three, five, even 10 years. Now you're tempted by funds that may not have even three months of performance history. Should you hitch a ride on one of these new fund rockets? Personally, I've never bought a brand-new fund. While I can't recommend something I wouldn't do myself, some of you may not be able to resist the kinds of returns I've just quoted. That's okay, as long as you understand the enormous risk you're taking, and as long as you follow the rules I give below.

The first thing to realize is that many of these dazzling debutants concentrate on two narrow, overlapping market niches: small company and aggressive growth. That's no accident. Those two sectors are hot right now, and success draws a crowd. As Robert Puff, chief investment officer at the Twentieth Century funds, puts it: "The industry collectively will keep introducing whatever has been working well lately." And so it has: Since the beginning of 1995, nearly 100 small-cap and aggressive growth funds have been launched.

Meanwhile, Wall Street has rolled record volumes of initial public offerings (IPOs), or stocks sold to the public for the first time--the favorite fuel of small-cap and aggressive growth funds. The result is a magical money launching pad: The new funds buy hot little stocks, making them hotter, driving up the funds' returns, attracting more money to the funds, heating up their favorite stocks further--and drawing more IPOs to market.

Beyond that, new funds have some natural advantages over their older rivals--and it just so happens that small-cap and aggressive growth portfolios get the biggest boost from most of them:

New funds are smaller. As I showed in the April issue of MONEY, the bigger a fund gets, the more likely its performance is to slow down as it swells up with a greater number of bigger stocks at higher prices. But funds are born small; by law, a fund must open for business with a maximum of 25 investors, who usually pony up a total of $100,000 to $1,000,000.

When customers pour $10 million of new money into a $1 billion fund, that's just a 1% cash inflow. But another $10 million at a $10 million fund is a 100% cash inflow. "If new cash is a very high percentage of total assets," says Ronald Baron of the Baron funds, "you can keep applying large sums into your best ideas."

Their managers are hungrier. Explains David Testa, head of equities at T. Rowe Price: "When you take a highly motivated individual, back him with substantial resources and give him a portfolio to call his own, the intensity of effort is something to behold." Funds generally don't make money for the management company until they take in about $200 million, so attracting assets with high performance right off the bat is the name of the game.

New funds get lots of TLC. Says Gary Pilgrim, skipper of PBHG Growth Fund: "New pools of money always get the firm's fresh ideas." Why? Partly it's just human nature. Michael Price of the Mutual Series funds, who introduced the Mutual European Fund in June, asks: "Do you have kids? Who gets the most attention--the oldest, or the baby?" Sure, Price's comment is self-interested; he wants lots of customers for his baby fund. But he has a point about tender loving care.

Ever heard of "incubator funds"? Back in the 1960s, recalls fund consultant Geoffrey Bobroff, money managers would start a bunch of funds and run them in secret for a few years. Later they would terminate the flops and trot out the surviving boffo funds for the public to buy. (Among many others, Fidelity Contrafund began this way.) The records of the lousy funds disappeared, making the firms seem better managers than they really were.

No one admits doing this today, but trust me: It's commonplace. One reason new funds do so well is that, by incubating them, the money managers know they have hatched a winner before they announce its birth. Fund expert Michael Lipper of Lipper Analytical Services observes tartly: "The firms say the funds they bring out are the only funds they tried. If so, that's truly a wonderful occurrence."

Another form of TLC is "bootstrapping." That means the newest fund in a family gets first crack at a hot little stock. Then the firm's older, bigger funds pile into the stock, driving up the price and boosting the new fund's return. There's nothing inherently unethical about bootstrapping, but you need to bear it in mind when you evaluate the long-term "skill" of a new fund manager.

Bootstrapping gives the biggest bang for the buck in a market, like today's, that is rife with initial public offerings. That's why when I asked Lipper about the "new fund phenomenon" he joked, "Oh, you mean the IPO phenomenon."

Listen to Bob Puff of Twentieth Century: "If there's an interesting IPO, maybe we can get 50,000 shares total. If it's a $20 stock, that's $1 million. In a $15 billion fund, $1 million is too small to make an impact, but in a new fund it could make a big difference. So we would allocate the IPO shares where they would make the biggest difference, given the charters of the funds."

New funds don't have to sell one stock to buy another. Wayne Wagner, president of Plexus Group, a consulting firm in Santa Monica, Calif., found in a study last year that the typical fund manager's buy decision added 0.67% to the fund's short-term return--but the average sell decision subtracted 1.08%. Why? Natural optimists, fund managers are better at sensing when a stock is improving than when it is decaying. And selling a weakening stock can hurt the price further. Thus the manager of a new fund, whose fresh cash makes him a constant buyer, has better odds of outperforming a bull market.

And baby funds can buy a lot faster, says PBHG's Pilgrim: "If a manager gets a new idea that we think should be a 2% holding in our funds, it might take 500,000 shares to get to that level [in $4.6 billion PBHG Growth], and that could take a week. But one of our new funds might need only 15,000 shares for a 2% position, and that might take only half a day." Wagner notes that this speed works best at aggressive growth and small-company funds that pile into stocks whose prices are rising fast. It doesn't help much at large-company or "value" funds that stick to slower-moving stocks.

As you can see, aggressive new funds have a lot going for them in today's market. However, warns Puff: "It's been a golden era for this kind of investing, but it can't last indefinitely." After nearly 15 years of mostly bullish markets, you're a lot more likely to be buying a new fund near a peak than near the bottom. Remember too that new fund managers tend to be bright young folks who've never been through a real bear market. Their magic may suddenly stop working when stock prices stop rising--and the advantage will revert to more experienced managers. That's why I want to give you my six rules for buying a new fund:

--Stick with names you know. Some big fund families with strong track records, notably Fidelity, Janus and T. Rowe Price, seem to have unusually powerful launching pads. Their new funds often beat the averages by 10 percentage points or more in their first year. But the fund industry overall is full of fizzles. According to the fund raters at Morningstar, of the 542 diversified U.S. stock funds introduced since the end of 1990, just 262--or 48%--have beaten their older peers in their first year. In other words, your odds of success are just under fifty-fifty. That's why it makes sense to stick to new funds from the biggest families, or from managers with long-term records at earlier funds.

--Stick with your overall strategy. You should never buy any fund just because it's new. Instead, you should first decide which category of fund you may need to add to your portfolio. Then weigh the alternatives. Thus if you've been thinking for a while that you need more international exposure, you might consider buying a new Europe fund. But if you already own plenty of small-cap and aggressive growth funds, don't bloat your portfolio with more of them.

--Keep an eye on expenses. New funds tend to have higher expenses because of their smaller asset bases--but they shouldn't be too far out of line. If a new fund's expenses are 0.5 percentage points higher than those of its older peers, I'd think twice; if one point or more higher, I'd skip it entirely.

--Keep your expectations realistic. At his earlier fund, Govett Smaller Companies, Garrett Van Wagoner racked up a 54.7% compound annual return over nearly three years. His brand-new Van Wagoner Emerging Growth fund is up 56% in just the first five months of this year. If you think he can keep doing this much longer, you shouldn't be investing; you should be in psychoanalysis.

Van Wagoner's numbers have triggered a buying panic. Emerging Growth and his two other new funds have taken in more than $1 billion in five months. I hope his new investors realize that while much of Van Wagoner's success comes from his skill, much of it also comes from his being in the right place at the right time.

--Buy for the long run. Don't try to "flip" funds for a quick profit; it's a loser's game that only the Internal Revenue Service could love. What you gain in return you will give away in taxes. Instead, live by the same rule for new funds I suggest for all others: If you can't commit to owning this fund for five years or more, don't buy it.

--Make sure you can take the heat. Research by professors Erik Sirri of Babson College and Peter Tufano of Harvard shows that the managers of fast-growing funds know that many new customers sign on if big risks pay off, while few sell if the risks end up losing money. Thus they can be tempted to go for broke. And if the market stumbles, new funds in high-flying categories like aggressive growth are likely to come crashing down. Oberweis Emerging Growth was launched in January 1987; in that year's October crash, the fund nosedived more than 40%, or nearly twice the market's swoon.

All in all, I think the best use for new funds is as a place to put your "mad money," the spare change you're willing to gamble with. There's nothing wrong with gambling a little, as long as you understand that's exactly what you're doing. New funds are a high-risk bet. Don't let anyone tell you any different. If you can't afford to lose at least half of what you're putting in, you shouldn't even think about it.