“You gotta have a gimmick,” Stephen Sondheim advised in the 1959 musical “Gypsy.” In the song, it's about how to roll them in the aisles at Minsky's. But, mutual fund marketers have made the same calculation, constantly introducing offerings that are designed to stand out from the crowd.
During the years of high energy prices in the 1970s and 1980s, for example, companies introduced oil portfolios. As technology stocks soared in the late 1990s, an outpouring of Internet funds appeared. Amerindo Technology focused on a narrow group of champions. Even more specialized choices included Turner B2B and Gabelli Interactive Couch Potato. Aside from the cute names, the chief problem with such funds is that they focus on short-term trends. Often as not, the gimmicky funds appear just as the wave is about to crash.
The New Wave
Now that technology is out of favor, new specialists have appeared, promising to produce returns in erratic markets. Consider Columbia Thermostat, a fund that is supposed to keep investors comfortable in all kinds of climates. Thermostat starts with the premise that we are headed for a decade of flat markets. In such choppy times, investors should sell as stocks rise and buy when they dip. To maintain discipline, the fund functions on autopilot. When the S&P 500 is between 1100 and 1150, the portfolio holds an equal amount of stocks and bonds. And every time the benchmark rises 50 points, the stock allocation is reduced by 5 percentage points. Though the fund is intriguing, it comes with an obvious flaw: Stocks rise most years, so the portfolio seems doomed to be overweighted in bonds and lag the averages over the long term. In fact, Thermostat trailed the S&P in its first two complete years, 2003 and 2004.
To be fair, Thermostat could yet turn hot. And just because a fund appears trendy does not mean that it will fail. Fidelity Select Energy and Vanguard Energy both started in the early 1980s as the energy crisis was peaking, yet both funds have served investors well for decades. What signals whether a fund will prove to be a solid choice or a short-lived gimmick? The key test is that worthwhile funds add a significant element to a portfolio, helping to diversify it. Gimmicky funds can play no important role. Below we will examine some specialized funds and decide whether they are keepers or short-term gimmicks.
Catch Me Now I'm Falling
With the U.S. trade deficit swelling, several funds offer protection against the falling dollar. They include funds that hold foreign currencies, such as Profunds Falling U.S. Dollar and Franklin Templeton Hard Currency. While these may only be suitable for small allocations, currency holdings rank as long-term keepers. When the dollar sinks, the value of foreign currencies increases for U.S. investors.
“A currency fund can provide a defensive element because it is not correlated with stocks or bonds,” says Robert Thompson, owner of Bay Capital, a registered investment advisor in Tampa.
Franklin's track record demonstrates the value of holding a bit of foreign currency. When the S&P 500 dropped more than 22 percent in 2002, Franklin rose more than 17 percent as foreign currencies climbed against the dollar.
Other funds designed for today's markets include principal-protection funds. Guaranteeing to return an investor's principal, the funds gained popularity after the market collapsed in 2000. Offerings include ING Classic Principal Protection and Pioneer Protected Principal. In the typical protected fund, you deposit a fixed amount, such as $20,000, which is invested for a set term of seven years or so. If the market rises, during the period, you get part of the gains. If the S&P slips, you get your principal back, minus expenses. For shaky clients who won't go near stocks any other way, principal protection funds may have some appeal. But most people should consider the funds an expensive gimmick, says Eric Jacobson, a Morningstar analyst.
Besides stocks, many principal-protection funds hold some zero-coupon bonds, which are guaranteed to produce a fixed return by a set date. The funds shift the amount of stocks and bonds, trying to achieve the best mix. If stocks collapse early in the term of the fund, the manager may move to a big stake in bonds, thus guaranteeing that the fund will not finish with losses. As an added layer of protection, the funds typically buy an insurance policy protecting against red ink. Partly because of the costs of the insurance policy, the funds tend to charge much higher expense ratios than average bond funds. Jacobson says that investors in the preservation funds often end up with high-priced fixed-income vehicles. “It's probably cheaper just to hold a stock fund and then get some protection by buying a conventional bond fund,” he says.
Seeking to provide income and positive returns, several new closed-end funds use covered calls, including Nuveen Equity Premium Income. In this strategy, the fund buys a stock, such as IBM. Then it sells an option on IBM, giving another investor the right to buy the shares at a fixed price. If the stock doesn't rise, the fund keeps the stock — and the income from the option sales. If the shares rise, the fund must sell the stock at the fixed price. In a flat market, the strategy can work. But if stocks crash, the option income may provide a weak cushion. Investors seeking a long-term keeper may do better with Gateway, a conventional mutual fund that has delivered steady returns using a somewhat different option strategy. Besides selling calls on stocks, Gateway also buys puts. These gain in value when stocks drop, protecting shareholders from losses. The approach has enabled the fund to return 7 percent annually for the past decade while avoiding major losses in down markets.
In their search for returns, some investors have turned to sector funds targeted to narrow industries. Such funds have produced uneven results. But one long-term winner is AIM Leisure, which owns casinos, broadcasters and other businesses. During the past decade, the fund has outdone the S&P 500 by a wide margin. Portfolio manager Mark Greenberg attributes part of his success to the fact that leisure industries have been growing, steadily absorbing a larger percentage of the country's gross domestic product. “I don't know what the economy will do this year, but over time there is a good chance that leisure spending will grow faster than the economy as a whole,” he says.
Greenberg typically buys steady growers that sell at modest market multiples. The fund, which fits in Morningstar's large-growth box, makes an appealing diversifier for value-heavy investors who are wary of technology stocks.
Like other specialized choices, AIM Leisure can help balance a portfolio, enabling investors to cope with difficult markets.
|Fund||Ticker||Category||1-year Return||3-year Return||5-year Return||Maximum Front-End Load|
|AIM Leisure A||ILSAX||Large Growth||7.2%||5.6%||3.3%||5.5%|
|Fidelity Select Energy||FSENX||Natural Resources||45.5||16.1||11.2||0|
|Franklin Templeton Hard Currency A||ICPHX||World Bond||7.4||14.7||6.7||2.25|
|ProFunds Falling U.S. Dollar||F05NC7||World Allocation||N/A||NA||NA||0|
|Source: Morningstar. Returns through 3/31/05.|