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An Appealing Idea Does Not Necessarily Make for a Good Fund

You can't invest in concepts, only real-world investment options.

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Over the years, some respected equity investors have stated slightly differing versions of a sound and enduring principle. They don't think of companies being attractive or unattractive in isolation. Rather, they think of what makes for a reasonable or an unwise investment, at which specific price.

That's an idea most people can appreciate.  Apple (AAPL) or  Google (GOOG) may be excellent companies, but whether or not they constitute attractive investments at their current prices and valuations, or at higher or lower ones, is an entirely different matter.

The same principle, in slightly different form, applies to funds. There, the question goes beyond price to include other issues as well. Investors know that, but sometimes, when an investment looks enticing enough for certain reasons, it can be tempting to overlook such details.


Fine Print That's Worth Remembering
When fund documents compare fund performance to the performance of benchmarks, they typically include a boilerplate disclaimer pointing out that the index--unlike the fund in question--doesn't have to subtract fees and can't be invested in directly. In other words, you can invest in an S&P 500 Index fund, but you can't actually invest in the S&P 500 Index.

The same thing holds true for investment ideas or concepts or themes. You can't directly "invest" in an idea such as world peace or a country's GDP growth. A fund that tries to take advantage of investment opportunities that may coalesce around broad themes must deal with that challenge. Funds have to invest in stocks, bonds, or other securities. They have to find managers adept at choosing the right ones to invest in at the right times, and who can adapt to inflows and ouflows to the fund, among other things. And such funds don't come for free.

Fast-Growing Markets Don't Necessarily Equal Worthwhile Funds
For these reasons, the fact that a fund invests in a promising theme doesn't make the fund itself promising. When the concept of the BRIC countries first appeared, for example, it seemed in part a ploy to draw attention to Goldman Sachs, the firm that coined the term. Brazil, Russia, India, and China had some things in common, but they differed in other respects. Did they really need an acronym? That said, these were prominent emerging markets seemingly with years of rapid growth ahead of them, so the idea of investing in the group had some logic to it.

But did it therefore make sense to send a check to a BRIC-themed mutual fund? That's a different question, for it depends on the fund's traits.  Templeton BRIC (TABRX) came out in 2006. Besides the load (the A shares cost 5.75% up front if an investor doesn't have a way of bypassing it), the fund has charged an exorbitant fee. For its first five fiscal years, the expense ratio on its A shares--where the bulk of its assets resided--has topped 2% every year. For fiscal 2011, which ended this past March, the fund's expense ratio was a startling 2.11%. Even among front-load, emerging-markets funds--a depressingly costly group--that's far above average.

The fund can't try to excuse that high cost with a minuscule asset base, either; it has about $650 million in assets. Earlier this year, the fund finally trimmed its management fee. But its latest prospectus, issued Aug. 1, 2011, estimates that even with that reduction taken into account the expense ratio will come in at 1.97%.

The fund's performance won't turn any heads. For the five-year period through Sept. 23, 2011, its annualized return of 2.3% is 1 percentage point behind the average for the diversified emerging-markets category.

Goldman Sachs BRIC (GBRAX) also came out in 2006. That one's expense ratio for the first half of 2011 (annualized) was 1.87% for A shares. Prior years were higher. At least this fund's returns have topped the diversified emerging-markets category average over the trailing five-year period, bolstered by a triple-digit gain when the markets rallied in 2009. But shareholders had to endure a 65% loss in the bear market from late 2007 to early 2009, 5 points worse than the broader category average. 

The fund has also had to deal with management changes over its rather brief history--another way that real-world funds differ from the concepts that inspired them.

Keep an Eye on That Concept Fund
Socially aware investments have the same issues. Some can be worthwhile as investments in addition to allowing certain individuals to align their investing practices with deeply held beliefs. But price, management, and strategy play important roles here, too.

Even when a fund may pass such tests, it's worth checking back in from time to time.  Domini Social Equity (DSEFX), run by one of the most experienced and active firms in the socially aware arena, had an expense ratio of 0.95% in 2006. That's not cheap for no-load shares of a large-cap domestic-equity fund, but not too unreasonable either. However, the fund shifted from a passive strategy to active management in late 2006, and its expense ratio rose the next year.  That figure has continued to climb every year since then. For the first half of Domini Social Equity's fiscal 2011, its annualized expense ratio was 1.25%.

For a more damaging example of what can go wrong when investing in a fund that might appear to have laudable aims, look to DWS Climate Change (WRMAX). That fund's sorry history was outlined in a summer 2010 column. Suffice it to say things have not improved since the column's publication. Over the trailing 12-month period, the fund has lost 20.7%, a decline 15 percentage points worse than the world-stock category average. Recently, it changed its subadvisor and its manager, and on Oct. 1 it will take a new name: DWS Clean Technology.

Whether a concept is as new as clean technology or as old-fashioned as gold, has a catchy acronym, an attention-getting theme, or simply tracks an index, it doesn't qualify as a compelling investment unless it has several important traits in place. Without experienced management boasting a solid track record, a logical strategy, and a reasonable price, a fund will have a hard time making its case. That's true no matter how much its concept may, in the abstract, rest on solid evidence and fit with your principles or interests and align with your long-range investing goals.

Gregg Wolper does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.