Focused And Then Some

Competing fiercely for the attention of investors, fund companies have brought out a wave of specialized offerings. Many of the choices — which include mutual funds and exchange-trade funds — focus on hot-sounding industries, or growing areas of the emerging markets. Among the new names are: HealthShares Cardio Devices, Claymore S&P Global Water, and T. Rowe Price Africa and Middle East. The introduction of narrow funds is hardly new. In the late 1990s, the fund industry brought out dozens of Internet funds. In the 1950s, investors could buy the Television-Electronics Fund and Missiles-Rockets-Jets Fund. Although they are designed to exploit hot investments, narrow funds typically appear just as those investments are peaking. Alas, investors often jump aboard just before the hot dots — and the vehicles intended to exploit them — cool.

In my opinion most of the latest generation of specialty portfolios will undoubtedly fall by the wayside. Recently, Claymore Securities announced that it was liquidating 11 of its fledgling ETFs, including Claymore/Clear Global Vaccine Index and Claymore/KLD Sudan Free Large Cap Core.

Proponents of narrow funds argue that not all the offerings are doomed to fail. The largest supplier of specialty funds is Fidelity, which offers 43 sector funds, including Fidelity Select Air Transportation and Fidelity Select Chemicals, both started in 1985. But from a business standpoint, narrow funds are iffy propositions. “The Fidelity sector funds are training grounds for analysts who also work on the big diversified funds,” says Jeffrey Ptak, a Morningstar analyst. “Most narrow funds disappear because companies can't afford to subsidize them for very long.”

Part of the reason for the flurry of new funds can be traced to the changing nature of the market for ETFs. Up until now, ETFs have been index trackers, and during the past decade a few big companies, including Barclays Global Investors and State Street Global Advisors, have dominated the market. These leaders were the first to track major benchmarks, such as the S&P 500 and the Russell 2000. Now that the obvious territory has been taken, startup companies must find different indexes to track.

To stake out ground, ETF entrepreneurs have been seizing on newly created benchmarks. Market Vectors TR Gold Miners tracks an index that includes mining companies with market capitalizations of more than $100 million. Many of the new ETFs mimic slices of the emerging markets. SPDR S&P Bric 40 holds a cross section of big stocks in Brazil, Russia, India and China.

Some advisors are wary of the new selections simply because they are untested: “We concentrate our efforts on large-cap U.S. stocks and other assets classes that have track records going back decades,” says Thomas Mench, a financial advisor in Cincinnati. “It is not clear that a China fund will add any value to what we already use.”

Mench is leery of startups because tiny funds often have high expense ratios and trading costs. When a fund only has $2 million in assets, the costs must be borne by a small number of shareholders. And if the small portfolio does liquidate, investors could be saddled with taxable capital gains — and the headache of finding a new investment.

Anyone who is considering a tiny new fund must make an extra effort to analyze the investment, says Jeffrey Ptak of Morningstar. “Money tends to flow to prudent investments,” says Ptak. “If a fund only has a few million dollars in assets, you have to ask yourself why other investors aren't interested.”

Ptak also cautions that some of the new investments may not provide the exposure that their names suggest. For example, First Trust ISE Water Index has held ITT, an industrial company that makes defense electronics as well as equipment that is used to treat water. “If you want a pure play on water, then you need to look closely at the portfolio and see if that is what you are getting,” he says.

Another fund that troubles Ptak is Claymore/Clear Global Timber. The name could suggest that the fund holds timberland, a popular investment for institutions because it has low correlation with stocks. In fact, Claymore owns stocks, such as International Paper, that tend to move up and down with the broader equity markets.

While investors should avoid most of the narrow funds, advisors say that some of the new choices may be worth considering. At a time when the dollar is sinking, portfolios can be diversified with the addition of funds that invest in foreign currencies, such as the Swiss franc or the Japanese yen. ETFs that enable investors to hold currencies include CurrencyShares Swiss Franc and CurrencyShares Euro. As the dollar falls, the foreign currencies become more valuable for U.S. investors. In addition, many of the foreign currency ETFs pay yields of more than 3 percent, a solid return for a high-quality fixed-income holding. “With the currency funds, you can diversify your portfolio and get nice yields,” says financial advisor Thomas Mench.

Some advisors argue that new commodity funds may also have value. Choices include PowerShares DB Base Metals and PowerShares DB Agriculture. Metals and agriculture products have long track records for delivering returns that don't correlate with stocks. But up until recently, it was generally difficult for retail investors to take positions in copper or corn. “Now you can buy ETFs that take advantage of the growing demand around the globe for commodities,” says Tom Lydon, president of Global Trends Investments, a registered investment advisor in Newport Beach, Calif., that clears trades through Charles Schwab.

To be sure, the commodity funds can be volatile. But by carefully using a few of the specialized new choices, advisors may be able to be build thoughtful portfolios that will deliver competitive long-term returns.

NARROW FUNDS, BROAD APPEAL

While investors should avoid most specialized funds, these can help to diversify portfolios.