Avoid These Trendy Funds

One of the key questions we look to answer with  Morningstar Stewardship Grades for funds, which we re-launched two weeks ago, is whether the firm focuses more on stewardship or salesmanship. Firms that are focused on salesmanship often do whatever it takes to make a quick buck. Top stewards, by contrast, take a sober, fiduciary approach to money management.

When they launch new funds, companies tip their hands about whether the salesmen or the stewards are running the show. If a fund shop rolls out funds that fill a valuable role in investors' portfolios, that investors are apt to use wisely, and that play to a firm's investment strengths, that's a strong clue that the stewards are driving the agenda. On the other hand, firms that launch gimmicky, ripped-from-the-headlines funds invariably have short-term asset-gathering as their top priority.

When I look across the funds that have launched over the past year, I'm happy to see that many shops seem to have gotten religion about not bringing trendy gobbledygook to market. Among the recent launches, I see a surfeit of target-maturity and global funds, both of which are viable investment categories.

At the same time, some of the new funds--particularly exchange-traded funds--do fit the description of gimmicky or at least ill-timed. (Healthshares Orthopedic Repair HHP, anyone? As Dave Barry would say, I am not making this up.)

Here are some of the most notable fund types that most investors can live without, particularly right now.

Currency Funds
Whether you're planning a trip to Italy or cracking open your latest copy of Newsweek, it's hard to avoid the steady drumbeat of bad news about the dollar. Fund companies--particularly ETF purveyors--have rushed in to fill the "void" over the past few years, providing vehicles for investors who want to speculate that a single currency will appreciate or that the dollar will continue to slump. Yet betting on the direction of a currency is a notoriously risky game where success depends on getting a huge number of macroeconomic calls right. (For proof, just ask all those investors who, witnessing the dollar's slump in 2003 and 2004, decided to bet against the greenback. In the following year, 2005, the dollar surged about 15% versus both the yen and the euro.) Don't get me wrong--there's ample reason to make room for foreign-currency exposure in your portfolio, but it's best to obtain it by holding an unhedged, diversified foreign-stock or -bond fund for the long run rather than trying to guess the direction of a single currency over the short term or mid-term.

Long-Short Funds
It's a stretch to call long-short funds a gimmick, as some investment managers--particularly in the hedge-fund realm--have delivered strong risk/reward profiles with the strategy. Still, I'm unconvinced that most investors need a long-short fund, and I'm even less convinced that most of the new long-short funds are a good value proposition. These funds use a variety of strategies but generally take long positions in some stocks while shorting others, with an eye toward delivering positive returns in a variety of market conditions. So far, so good, right? Not so fast. Stocks over long periods of time have returned 10%, give or take, and long-short funds will tend to generate returns that are lower than stocks. (The five-year annualized long-short category average is just 6%, versus a 12% gain for the S&P 500.) When you consider that the average long-short fund launched over the past year has an expense ratio of more than 2%, it's hard to see how you'd be better off in a long-short offering than in a plain-vanilla bond fund. The case for long-short funds is even weaker for investors' taxable assets, because the strategies tend to be tax-inefficient.

Single-Commodity Funds
I can get behind the idea of investors devoting a small share of their portfolios to a broad basket of commodities, assuming they plan to buy and hold through the rough patches. (That's a pretty big assumption, by the way; check out Karen Dolan's  most recent analysis of PIMCO's commodity fund.) While commodities have sky-high volatility on a stand-alone basis, their correlation with U.S. stocks is close to zero, making them effective portfolio diversifiers. Where you lose me, though, is with funds tracking individual commodities such as agricultural products and base metals. Unlike a company, where you can arrive at a fair value by modeling the cash flows of the business, it's extremely difficult to forecast commodity prices with a high degree of accuracy. Speculators might like single-country funds, but true investors should pass them by.

Exotic Specialized Foreign Funds
It's arguable whether anyone needs a fund dedicated to emerging markets, and even more debatable that it's a good time to launch, buy, or add to your holdings in such an offering. More questionable still are these newfangled emerging-markets funds that focus on a handful of countries thought to have the brightest future prospects. Companies have rushed to market with BRIC funds (focusing on Brazil, Russia, India, and China) and First Trust even launched a "Chindia" ETF  a few weeks back. I know there's a huge volume of data to suggest that these markets should continue to grow at a far more robust rate than the rest of the world, but I still think these funds are a bad idea. There's the obvious concern that each of these markets has had a tremendous runup over the past several years and therefore carries high valuation risk. My bigger objection, though, is that it's hard to see why you'd want to have a fund that's artificially limited to these markets, particularly given that they have little in common despite hot growth prospects and ripped-from-the-headlines, trendy appeal. If growth in these markets slows down or, perhaps more important, another economy emerges as the next hot market, wouldn't you like your manager to have the latitude to invest there? I certainly would.