Specialized Funds Fail Investors

Noncore funds have been used poorly for years, but there are signs of hope

John Rekenthaler 20 December, 2016 | 15:50
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As a first approximation of the truth, it’s fair to state that specialized funds are useless. By “specialized funds,” I mean any funds that are not core holdings. Examples include sector funds, regional or country funds, niche bond funds, and most alternative-investment funds. By “useless” I mean that such funds do not make money for their shareholders. They might perform well on paper, but they fail their owners in the real world, because investors typically buy those funds high and sell them low.

The relative performances of these categories, of course, vary over time. To thoroughly mix the metaphor (and split the infinitive), a given category periodically bubbles to the surface by posting relatively high returns. After that happens, people write articles about those funds. Fund companies promote their wares, informing us about how their offerings are strategic investments that belong in everybody’s portfolio. Clients inquire. Advisors listen.

Submerging Markets

And then, before we know any differently, it’s the mid-1990s. Emerging-markets stock funds are at top of the pot. Tens of thousands of advisors have put emerging-markets funds to their clients’ portfolios. Investors who buy their funds directly have also become interested. Fidelity launched its first emerging-markets fund in 1990; by the middle of the decade, Vanguard and then T. Rowe Price had joined the party. Firms that viewed themselves as cutting edge, spurred by overeager members of their investment committees, added emerging-markets funds to their plan lineups.

Boom! The Asian crisis strikes. The average emerging-markets stock fund plunges 30% within 15 months. Some investors hold their shares, which doesn’t get them very far, as the category ekes out only a modest gain for the next three years. Some retreat to cash, which leads to a similar result. And some--the least fortunate--opt to swap their losing high-risk asset class for an asset that is most certainly winning as the New Millennium approaches: technology stocks.

That, to be sure, is a dramatic example. But it typifies the problem with specialized funds. Time and time again, investors buy such funds with the intent of holding them for a long while. They believe that they have made a strategic investment. This decision occurs after the funds have enjoyed several good years, and when they are due for a downturn. Soon, this sell-off occurs, the newly purchased specialized fund plummets, and the investor considers cutting his losses. There are so many better places for his money.

Looking Forward

That was how fund shareholders used Fidelity’s sector funds in the 1980s, when I started covering the mutual fund industry, and that is how shareholders use the much wider variety of specialized funds that is available today. Thirty years of going nowhere. I am cautiously optimistic about the next 30 years. Three current trends should bring improvements.

Investment transparency

Most specialized funds are actively run, either by traditional investment management, or quantitatively with algorithms that are known only by their creators. Either way, shareholders are often left guessing. They wish to establish sound, rationally based expectations for their holdings, but it’s difficult to accomplish that task without access to a historic track record--which generally cannot be provided for such funds.

In contrast, many of the newer specialized funds are open about their investment strategies. They use widely available research, and disclose most (if not all) details about their investment processes. Such information makes for better shareholders. To be sure, the financial markets can and will deliver unpleasant surprises--but these will be the smaller surprises that accrue to index-fund investors, not the larger shocks suffered by less-fortunate investors in actively managed funds.

Lower costs

Historically, specialized funds have charged handsomely. Many have expense ratios of greater than 2% per year, several times those of the cheapest core mutual funds. Such costs not only reduce the short-term returns of those funds, thereby making their performances during downturns that much worse and their shareholders that much likelier to bail, but they also threaten the funds’ long-term sustainability. Few investment strategies can withstand a 2% annual haircut.

Those costs are slowly declining. The process is, to be sure, two steps forward and one step back, but thanks in large part to the growth in ETFs, there now exist several hundred specialized funds with expense ratios of less than 1%. (Back in the day, that distinction was primarily owned by Vanguard’s sector funds.) Eventually, I think, all but the most specialized funds will need to become cheaper yet, say under 0.50% per year. Whether that will occur remains to be seen. But progress is being made.

Portfolio solutions

The third and final improvement has come primarily from target-date funds. As all-in-one offerings, target-date funds often contain specialized investments, along with the standard holdings of U.S. stocks, foreign developed-markets stocks, and high-grade bonds. That is a good thing. While professional investment managers are certainly capable of misusing specialized investment strategies, just as retail buyers have done, they nevertheless have the best training and preparation for the task.

Ideally, then, additional types of allocation funds will become popular, so that retail investors will primarily hold their specialized assets through such “solution” funds. Specialized funds will continue to exist. However, if things develop as I believe they will, specialized funds no longer will be thought as the normal way to improve portfolio diversification. They will instead be regarded as, well, for specialized tastes.

 

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John Rekenthaler  is vice president of research for Morningstar.

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