4 Niche Funds for a Sliver of Your Portfolio

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Investors with truly diversified portfolios might consider holding a few specialized funds around the margins of their portfolios. Joining me to share a few of his favorites is Russ Kinnel. He is director of manager research for Morningstar.

Russ, thank you so much for being here.

Russ Kinnel: Glad to be here.

Benz: Russ, let's talk about specialized funds. When we talk about specialized or niche funds, what kinds of funds are we talking about?

Kinnel: There are often areas that focus on small parts of the market. In other words, the total market cap isn't that big. So, it could be a certain region or an investment type that's not that big. And generally, when we look to these, we are looking for some mix of diversification, because it doesn't act like the broad market and/or value-add. So, good little niche alpha generators. So, useful players used in moderation.

Benz: So, that was my next question. If I want to use some of these funds that we are going to be talking about, what should be on my to-do list first? I assume that I should have a well-thought-out asset-allocation plan and some of the core type funds first.

Kinnel: That's right. Build out your core. And I think niche funds are fine, but you don't want to build a portfolio that's all these niche funds. Niche funds can be kind of exciting; you hear about something in the headlines, you buy a fund. You don't want to have 10 of these funds taking up a third of your portfolio. So, be disciplined. Have a couple. Don't go crazy with them.

Benz: So, let's talk about some of the ones that you really like. One is a foreign smaller-cap fund. So, this would be maybe a complement if I have my core international stock holding, I might hold a little bit of this one as well. This is an Artisan fund. Let's talk about it.

Kinnel: Artisan International Small and Mid-Cap is run by Rezo Kanovich who came over from Oppenheimer in October of 2018, and he really changed the fund into an aggressive growth fund. We saw him at Oppenheimer. He had tremendous success with that strategy. But, to me, because it's a very aggressive strategy, I don't think it's really a core holding. I think it's one I might make, say, 5% of my portfolio. Again, very aggressive investor. And I like the fact that right now it's a fairly small fund, under $1 billion. Artisan has a good record of closing funds before they get too big. Oppenheimer is a little more shaky at closing funds. So, I like it when a manager goes from that kind of shop to one like Artisan. So, I see a lot of positives there. But again, I would be cautious because it is an aggressive fund.

Benz: When you and I were talking about which funds to talk about here, you sent me three Matthews funds. We settled on one. First, let's talk about what you and the team like so much about Matthews and what their specialty is.

Kinnel: So, their specialty is investing in Asia, and they do it really well with a big team of managers and analysts all dedicated to Asia. They typically favor kind of a growth-at-a-reasonable-price strategy, tend to be a little lower in market cap. So, they are not just owning Samsung or the household names--they go beneath that. And so, we've really come to like them as a firm that just has a lot of expertise, a lot of people who make a career investing in Asia.

Benz: So, Matthews Emerging Asia is the fund that you are highlighting here.

Kinnel: Right. So, this is very much a niche fund. If the Artisan fund was a 5%, this fund maybe should only be at 2% because it's a niche within a niche. It's focusing on emerging Asian. So, what that means is, forget about Korea, Hong Kong, and China, the giants of Asia--

Benz: --Or Japan.

Kinnel: Or Japan. This is a fund that's investing in Pakistan and Bangladesh and Sri Lanka--some of the smaller markets. So, again, I think it's got a sensible approach. They have very experienced managers despite it being a relatively small fund and a small niche. So, I like all of those things. But again, it's a niche fund. You have much lower correlation with the U.S. market. It's about a 30 correlation with the EAFE as well. And so, it's a better diversifier because these markets move differently. But again, they truly are emerging markets with higher risk. It actually has a lower standard deviation than the S&P 500. But don't trust that--it's a high-risk strategy.

Benz: And these two funds, the Artisan fund and the Matthews fund, they are also not cheap relative to my big core foreign stock fund, most likely.

Kinnel: That's right. That's another reason to keep these funds at a small amount. They are cheap relative to their peers in those categories. Particularly, the Matthews funds are generally pretty cheap. But right, they are pricier. So, that's another reason you want to keep that smaller. The most of your portfolio should be in low-cost core funds.

Benz: Another fund that you like, a U.S.-focused fund, is Fidelity Select Health Care. This is one space where you'd want to do a good survey of what you've already got in your portfolio before adding on dedicated healthcare exposure, right?

Kinnel: That's right. Your typical growth fund is going to have meaningful healthcare exposure. So, it's a good thing to run your portfolio through Morningstar X-Ray or some other tool that says "How much do I have exposure to this area" before you add to it. But I think what's appealing here is that Fidelity has built a really good team of analysts under Eddie Yoon. They have 15 dedicated healthcare analysts with a wide range of medical specialties. And so, they really know the space. So, to me, this is a space where you can really get some good value-add. But again, you are right, in this case you are going to have some overlap. It's not going to be as much a diversifier as an alpha-generator for you.

Benz: The last fund on your list is, I think, truly an interesting diversifier idea. So, if I've got my core equity, my core fixed income, Gateway Fund is another fund to consider. Let's talk about that one.

Kinnel: This is a very different fund from the other ones we've talked about. It's going to be less volatile and less risky than the market, whereas the other ones potentially are much riskier. The idea here is they own essentially the broad market, but then they do a collar strategy with options. And what that does is it significantly lowers the upside and the downside. So, in a strong bull market, it might only get a third of the upside. In a strong bear market, it might only lose half as much. So, it's a really nice diversifier in that way. But I think, to me, the risk here is a little sneaky. It's kind of opportunity cost, right, that you are giving up. You could have put that money in a straight equity fund and had greater upside even with the downside. So, again, to me, that says it's still a niche fund, but it's a nice diversifier, it's a nice way to tone down some of that equity risk.

Benz: Okay, Russ. Interesting ideas. Thank you so much for being here to discuss them with us.

Kinnel: Glad to be here.

Benz: Thanks for watching. I'm Christine Benz from Morningstar.com.