Watch Out for Trendy Funds

Has the fund industry learned its lesson? How frothy is the market?

You'll find some clues to both questions by looking at new fund launches, which are one of the key dividing lines between the fund companies that consider themselves fiduciaries and those concerned merely with accumulating assets. If you're in the latter group, you give investors what they want even if you suspect it might not be a prudent offering. What could be more cynical than launching a fund aimed at an asset class with sky-high valuations or a leveraged bond fund when interest-rates are at an all-time low.

If you're a fiduciary, on the other hand, you only roll out funds you expect will provide satisfactory results to investors, and you'll do so only when you have the expertise to back it up.

Calm Before the Storm?
In the past bull market, we saw a steady stream of Internet funds, funds to leverage sell-side research, and other bad ideas. Naturally, the launches were at their heaviest right before the bubble burst.

Judging by those standards, things look much more encouraging now than they did in 1999. There have been only a handful of really trendy launches over the past year, and as we've written, some gimmicky funds have adopted more sober mandates. However, the rally is only a year old, and fund flows only picked up in the fourth quarter of 2003. It takes some time to launch a fund, so the industry is really only being tested right now. If we see a slew of China funds and leveraged bond funds, it will be clear that some fund firms still have their priorities out of whack.

Speaking of China funds, Alger recently launched the China-U.S. Growth Fund. Never mind that speculative frenzies in emerging markets usually end in a very ugly way. To be sure, China's growth is real, and in addition to Chinese companies, the fund will own U.S. and other multinational stocks with connections to China. What is more dubious is that the growth will translate into long-term gains for holders of Chinese stocks. Back in the early 1990s, investors made a similar mistake over Mexico because they thought NAFTA would transform the country's market into a powerhouse.

Other Bad Fund Ideas
Some other launches wouldn't count as trendy, but I still think we could do without them. For example, some recently launched Rydex funds will track the S&P/Barra style benchmarks such as Large-Cap Value and Large-Cap Growth. The funny thing is, Vanguard recently chucked these benchmarks for its funds because they are based solely on price/book measures, and price/book just doesn't work for some industries, such as tech. If you want a style-specific fund, you now have plenty of low-cost options among traditional open-end funds and ETFs. And aside from having a flawed benchmark, the new Rydex offerings are also pricey.

There will probably always be funds that are ridiculously overpriced. The latest to qualify are an array of funds of funds that add a high fee on top of all the regular fees charged by the funds they buy. My favorites are the MurphyMorris ETF  and PMFM ETF Portfolio Trust , which charge you 2.5% and 1.8%, respectively, to invest in their ETF portfolios. Gee, I thought one of the selling points of ETFs was that they charge slightly lower fees than traditional funds. Then there's the MH Elite Fund of Funds , which charges investors 1.25%.

It's not trendy and it's not pricey, but I still wish that the T. Rowe Price Diversified Mid Cap Growth Fund (PRDMX) hadn't been launched. The fund operates in the same space as the giant, recently closed  T. Rowe Mid-Cap Growth Fund (RPMGX). T. Rowe insists there won't be a lot of overlap, but the funds will still draw from the same mid-cap research.

A few years ago, Putnam made a similar mistake of launching sequel funds, such as Voyager II, after closing the originals. They've since forsworn the practice. Fidelity was up to the same sort of shenanigans in 1998 when it launched Fidelity Contrafund II to be a leaner substitute to the massive  Contrafund (FCNTX). The firm's 2003 decision to change the Contrafund II's name to  Discovery (FDSVX) may be viewed as a tacit admission of the faulty reasoning behind launching it in the first place.