Blurred Lines for Funds a Mixed Blessing for Investors

Placing mutual funds into distinct asset classes and categories has obvious benefits. Without dividing funds into groups, performance rankings would be of limited use, as bond funds would be compared with stock funds, and small-cap funds with those that focus on multinationals. A top-quartile ranking might mean a fund had enjoyed investment success, or just that its slice of the market had been in favor.  

The problem is, not all funds fit neatly into a group. That's not new: For instance, many managers who use a moderately value-oriented stock-picking approach have long produced portfolios that tend to land around the border between value and blend. In recent years, though, fund companies have created many funds that by design challenge the existing classifications.

I'm not referring to "tactical" funds, which allow themselves the freedom to own almost anything and to change direction rapidly; they can be grouped with other like-minded rivals. Rather, I'm referring to funds that do have constraints, but which are redefining those boundaries.

The resulting flexibility has the advantage of allowing their managers more freedom to buy the securities they consider most appealing. But funds that adjust the boundaries can complicate the task of building a portfolio, especially for investors who favor specific asset-allocation targets or are simply trying to get straightforward exposure to a type of asset they currently lack.

The Emerging-Markets Menu Expands
Perhaps the clearest example of this phenomenon can be found in the emerging-markets realm. Twenty years ago, emerging-markets stock funds either looked at all emerging markets around the world or focused on a single country or region. Emerging-markets bond funds owned dollar-denominated government debt, for the most part. It was generally considered too risky to own bonds issued by emerging-markets companies rather than by governments, or to own either type of security denominated in local currencies, if enough such bonds could even be found.

But the emerging-markets landscape gradually has become much more varied. Lazard, Dreyfus, and other firms have assembled portfolios that combine emerging-markets stocks with emerging-markets bonds and other assets. Other funds (such as veteran  American Funds New World (NEWFX), around since 1999, and  Thornburg Developing World (THDAX), which appeared 10 years later) concentrate on emerging-markets stocks but also include many firms based in the United States, Europe, or other developed markets that have substantial emerging-markets exposure.

Meanwhile, among dedicated fixed-income offerings, a number of funds now buy emerging-markets bonds issued in local currencies rather than in dollars or euros, and debt from emerging-markets companies is no longer off-limits. Many funds, in fact, focus particularly on local-currency debt, such as  PIMCO Emerging Local Bond (PELBX), while  TCW Emerging Markets Income (TGEIX) is one of the few that puts all of these varieties in the same portfolio.

The innovations didn't stop there. As the biggest emerging markets, such as Brazil, China, and South Korea, grew and matured, a few intrepid souls started looking to so-called frontier markets such as Kuwait and Nigeria, whose stock markets are considered to be a step below emerging status. And fund companies weren't content to simply create frontier-markets funds and leave it at that. Several (including Harding Loevner Frontier Emerging Markets (HLFMX) and Wasatch Frontier Emerging Small Countries (WAFMX)) decided to blur the line and create portfolios that combine stocks from frontier markets with those from smaller emerging markets.

Worth a Look?
Although investors should be wary of new fund types--many trendy but unwise fund ideas have come and gone over the years--some of these rest on a reasonable footing. 

For example, there can be merit in including developed-markets companies with a broad presence in developing countries in an emerging-markets portfolio. While some emerging-markets firms dominate their local markets, in other areas multinationals such as  Unilever (UL) or Nestle or  McDonald's (MCD) also reap tremendous benefits from the rising incomes and increased consumer and infrastructure spending in rapidly developing parts of the world. Moreover, such a portfolio can exhibit less volatility than a pure emerging-markets stock fund, making it more likely that shareholders will hold on when stock markets shudder.

On the downside, some of the fund's holdings will likely duplicate those in an investor's U.S. and international funds, and returns won't soar as high in emerging-markets rallies as those of a "pure" fund will.

Similarly, fudging the boundary between frontier and emerging can make sense. Why let an index provider's classification determine whether or not the manager can invest in countries that could reasonably fall on either side of that line? Of course, most funds do have the discretion to invest a certain amount of money outside of their stated mandate, but broadening the mandate itself makes things clearer.

Whether each individual fund taking these approaches has appeal is another question, of course. Many of these funds have rather short histories and high expenses as well.

A Daunting Search
Broader issues also arise. Unless there are enough of these flexible funds to merit the creation of their own new categories, their existence can complicate an investor's evaluation process. (Morningstar generally waits until there are more than 20 funds of a certain type before creating a new category.)

For this reason, funds that invest in developed as well as emerging markets lie in the same category as "pure" emerging-markets funds. It can be difficult for investors to know from the funds' names which are which. Yet the performance differences can be vast, especially when emerging markets are enjoying strong rallies or enduring deep declines. Morningstar analysts and sophisticated investors with the right tools can create narrower, custom-made groupings, but that's neither quick nor easy to do.

Similarly, there are too few frontier-markets stock funds to merit a separate category. Even if more such funds existed, the fact that some of them include small emerging markets in their purview, while others do not, would complicate matters.

Besides the comparison issues, expanding the menu can create what researchers have called the paradox of choice. Some academic studies have found that, at a certain point, having too many choices confuses or frustrates people. Simply having to pick from among the huge number of funds that use familiar, standard approaches is daunting enough; adding many new fund types, each with its own roster of choices, deepens that problem. It's not hard to imagine that an investor who reads about the potential for emerging markets and decides to investigate the available options would soon become frustrated or baffled, and either make an inappropriate choice or simply give up.

How to Manage It?
Of course, no one would suggest that fund companies stop introducing new concepts. Some new fund varieties--probably a distinct minority, but some--will prove to be useful additions. Unfortunately, the proliferation of fund types can lead to more work for investors and advisors. Even those who choose the indexing route will find an incredible array of choices awaits them.

One way to reduce the burden is to focus most of your energy on selecting and monitoring a few solid, reasonably priced core funds for the more common asset classes, and then recognizing that additions to that foundation can be made sparingly, if at all. By limiting your forays into new-concept territory, you might miss out on the hottest areas some years. But with patience and dedication, chances are you'll reach your long-term goals.