Chapter 14

Specialty Funds: One of a Kind

In This Chapter

Looking into real estate investment trust (REIT) funds

Getting the scoop on precious metals and commodities funds

Reviewing utility funds

Doing good with socially responsible and market neutral funds

In the other chapters in this part of the book, I explain the three major types of funds: money market, bond, and stock. Specialty funds, which tend to be stock funds, are often known as sector funds because they tend to invest in securities in specific industries. But, as you see in this chapter, some specialty funds hold securities in a variety of industries but engage in unusual strategies that separate them from their peers.

In addition to real estate and precious metals funds, other types of sector-focused funds I discuss in this chapter are commodity funds, and utility funds, which are popular with some investors who want more conservative stock investments. In addition, I cover specialty funds that engage in unusual strategies and invest in a wide range of industries — socially responsible funds and market neutral funds.

Sector Funds: Should You or Shouldn’t You Invest in Them?

In most cases, you should avoid specialty or sector funds. Investing in stocks of a single industry defeats a major purpose of investing in mutual funds — you give up the benefits of diversification. Also, just because the fund may from time to time be dedicated to a hot sector (a sector fund or two is often at the top of short-term performance charts), you can’t assume that the fund will pick the right stocks within that sector.

Another good reason to avoid sector funds is that they tend to carry much higher fees than other mutual funds do. Many sector funds also tend to have high rates of trading or turnover of their investment holdings. Investors holding these funds outside of retirement accounts may have to turn over a tidy portion of their returns to the IRS.

The only types of specialty funds that may make sense for a small portion (10 percent or less) of your investment portfolio are funds that invest in real estate or precious metals. These types of funds can help diversify your portfolio because they can do better during times of higher inflation — which often depresses general bond and stock prices. Don’t feel obligated to invest in these sector funds, however, because diversified stock funds tend to hold some of these specialty investments.

Landlording Made Easy: Real Estate Investment Trust (REIT) Funds

Do you want to invest in real estate without the hassle of being a landlord? Invest in real estate investment trusts (REITs), which are stocks of companies that invest in real estate. These funds typically invest in properties, such as apartment buildings, shopping centers, and other rental properties. Of course, evaluating REIT stocks is a hassle, but you can always (you guessed it) invest in a mutual fund of REITs!

REITs are small-company stocks and usually pay decent dividends. Sorry, but these dividends aren’t eligible for the lower dividend tax rates for other stock funds. As such, REITs aren’t appropriate for higher-tax-bracket investors investing money outside of retirement accounts. Most of the larger, diversified U.S. stock funds that I recommend in Chapter 13 have a small portion of their fund’s assets invested in REITs, so you’ll have some exposure to this sector without investing in a REIT-focused fund.

Here are some solid REIT funds from which to choose:

Cohen & Steers Realty Shares has been managed by Martin Cohen and Robert Steers since the fund began in 1991. (Two additional comanagers have recently been added.) The minimum initial investment is steep at $10,000. Discounters also may offer it without transaction charges. Annual operating expenses are 1.00 percent. 800-437-9912.

Fidelity Real Estate Investment, the oldest REIT mutual fund, is managed by Steven Buller, who’s been with Fidelity since 1992 and managed this fund since 1998. This fund has expenses of 0.92 percent per year. Initial minimum investment is $2,500 ($500 for retirement accounts). 800-544-8888.

T. Rowe Price Real Estate has been managed since its inception by portfolio manager David Lee. 0.75 percent, $2,500 minimum ($1,000 for retirement accounts). 800-638-5660.

Vanguard REIT Index, yet another of Vanguard’s long line of index funds, has minimal expenses of just 0.21 percent. Although this fund will never be a star in its category, its low expenses should ensure its long-term success. Minimum investment amount is $3,000. The fund charges a $20, annual low-balance fee for account balances below $10,000 unless you register your account on Vanguard’s Web site for electronic delivery of statements and fund reports. 800-662-7447.

Profiting from What Everyone Needs: Utility Funds

Utility funds tend to attract older folks who want to earn good dividends and not have the risk of most stock investments. And that’s what utility funds are good for. But this once-staid industry has been shaken up by increased competition.

In a sense, utility funds are superfluous. Most diversified stock funds contain some utilities, and those investors who want income can focus on better income-producing funds, such as Wellesley Income in the hybrid group and the value-oriented stock funds that I discuss in Chapter 13.

Arming for Armageddon: Precious Metals Funds

Gold and silver have been used by many civilizations as mediums of exchange because these metals have unique physical properties and rarity. These precious metals are used not only in jewelry but also in less frivolous applications, such as manufacturing.

With a paper-based currency, such as the U.S. dollar, the government can always print more currency to pay off its debts. This process of casually printing more and more currency can lead to a currency’s devaluation — and to inflation.

Holdings of gold and silver can provide a so-called hedge against inflation. In the United States during the late 1970s and early 1980s, inflation rose dramatically. This rise depressed stocks and bonds. Gold and silver, however, soared in value, rising more than 500 percent (even after adjusting for inflation) from 1972 to 1981.

Over the long term, however, precious metals are lousy investments. They don’t pay any dividends, and their price increases just keep you up with, but not ahead of, increases in the cost of living. Although investing in precious metals is better than keeping cash in a piggy bank or stuffed in a mattress, it’s historically not been as good as bonds, stocks, and real estate.

Don’t purchase precious metals futures contracts. Futures aren’t investments; they’re short-term gambles on which way prices of an underlying investment (in this case, gold or silver) may head over a short period of time (see Chapter 1). You also should stay away from firms and shops that sell coins and bullion (not the soup, but bars of gold or silver). Even if you can find a legitimate firm (which isn’t an easy task), storing and insuring gold and silver are costly. You don’t get good value for your money.

Gold and silver can help to diversify a portfolio, but if you want to invest in precious metals, you’re wise to do so through mutual funds. For more information about determining how these types of funds may fit with the rest of your investments and how to buy them, be sure to read Chapter 12.

Vanguard Precious Metals and Mining fund, like most gold and precious metals funds, invests in mining companies’ stocks worldwide because many are outside the United States in countries such as South Africa and Australia. This fund, which also invests in other metals such as platinum and nickel, has one of the best track records among precious metals funds and has been around since 1984. Annual operating expenses for this tax-friendly fund are 0.40 percent. At the time this book went to press, this fund was closed but will likely reopen, probably when this market sector isn’t overheated as it has been recently. Minimum initial investment is $3,000. The fund charges a $20, annual low-balance fee for account balances below $10,000 unless you register your account on Vanguard’s Web site for electronic delivery of statements and fund reports. 800-662-7447.

If you expect high inflation or if you just want an inflation hedge in case you expect the end of civilization, you could invest in a gold and precious metals fund. But these funds have wild swings and aren’t for the faint of heart or for the majority of your portfolio. To illustrate why, consider this: In 1993, the Vanguard Precious Metals and Mining fund rocketed up 93 percent, whereas in 1997, it lost almost 39 percent. From 2000 through 2007, it increased in value more than 600 percent! But, then in 2008, this fund lost a whopping 56 percent. In 2009, it jumped 76.5 percent. For an alternative, less volatile (and lower return) inflation hedge, consider investing in inflation-protected Treasury bonds (which I discuss in Chapter 12).

Commodity Funds

Precious metals are but one type of commodity. The major commodities that trade include energy commodities (such as oil, gasoline, and natural gas), grains and other agriculture commodities, industrial metals (such as titanium, aluminum, stainless steel, nickel, and copper), and livestock.

A number of mutual funds invest so as to track or beat various broadly diversified commodity indexes. Here are the notable attributes of commodities as an investment class:

Modest returns: Long-term commodity returns are comparable to those on bonds but certainly less than stocks.

High volatility: Commodities tend to be at least as volatile as stock prices without offering as high long-term returns.

Diversification value: Historically, commodities have posted their best returns when stocks and bonds have done poorly. For example, this situation happened during a portion of the 1970s, when commodities did well during times of increasing inflation. Thus, commodities add some diversification to a portfolio.

Plenty of poor commodity funds, including exchange-traded funds, are out there. In addition to high fees, funds in this space are often plagued by poor long-term returns due to excessive risk taking that doesn’t pan out.

Commodity funds should never be used for more than a small portion (say, 10 percent) of your portfolio, you should primarily use them for their diversification value. Because of their volatility, commodity funds are best used over several or more years, as you would use a stock fund.

Here’s a short list of some of the better commodity funds available:

Credit Suisse Commodity Real Return Strategy

Fidelity Global Commodities

Harbor Commodity Real Return Strategy

PIMCO Commodity Real Return Strategy

Hedging: Market Neutral (Long-Short) Funds

In Chapter 6, I discuss hedge funds. As I have in prior editions of this book, I warn investors about the many dangers of such funds, which lure investors with the promise of expected high returns and the possibility of doing well even when the stock market is doing poorly. Many hedge funds sell stocks short — a strategy that makes money when stock prices fall, but that typically leads to losing money. Often overlooked are the high fees, big risks, and relatively poor to mediocre long-term performance of most hedge funds.

The mutual fund industry developed market neutral funds, also known as long-short funds, as yet another answer to investor fears about falling stock market prices. A typical market neutral fund invests in stocks, which its fund manager believes will rise in value, but also shorts some stocks that the fund manager thinks will fall in value. (When you sell short, you borrow a security from a broker, sell it, and then hope to buy it back later at a lower price.) Supposedly, such funds shine during a volatile market because plenty of stocks should be rising and falling, and a smart manager, so the theory goes, should be able to invest in those that will rise and short those that will fall.

Well, this category of funds has generally failed to deliver for investors, which is why I haven’t recommended these funds in prior editions of this book. Consider the following issues with market neutral funds:

High expenses: The average expense ratio is a whopping 2.07 percent. One reason is the high costs involved in short selling. Paying more than 2 percent per year in fees is a major drag on your potential long-term returns.

Lack of track records: Of the 235 funds engaging in this strategy, only 65 have a five-year track record, only 19 have 10-year track records, and only 8 have 15-year track records.

Mediocre returns: In the five-year period ending April 7, 2010, which includes a fairly volatile period of rising and falling markets, the average market neutral fund posted an annual average return of just 1.9 percent. Over this same period, diversified funds generally returned double to triple that amount.

If you’re skittish about investing in stocks, then you need to develop an overall investment plan which includes holding a diversified portfolio. Ultimately, if you’re uncomfortable putting any money in stocks, then don’t do so. Investing in funds that short stocks is even more dangerous and risky.

Matching Morals to Investments: Socially Responsible Funds

Socially responsible mutual funds appeal to investors who want to marry their investments to their social principles and avoid supporting causes that they feel are harmful. These funds attempt to look at more than a company’s bottom line before deciding to commit their investors’ capital. Many of these funds consider such factors as environmental protection, equal employment opportunity, the manner in which a company’s employees are treated, and the level of honesty that a company displays in its advertising.

I can certainly understand the desire to put your money where your mouth is; unfortunately, socially responsible funds fail to bridge the gap between theory and practice. If you blindly plunk down your money on such a fund, you may be disappointed with what you’re actually getting. Bear with me as I explain.

Evil is in the eye of the beholder

The biggest problem is that the term socially responsible has different meanings for different people. Sure, most socially conscious investors can agree on some industries as being “bad.” The tobacco industry, associated with hundreds of thousands of deaths and billions of dollars of healthcare costs, is an obvious example, and socially responsible funds avoid them. But most industries aren’t so easy to agree on.

For example, McDonald’s is the world’s largest fast-food (hamburger) company, as well as a stock that some socially responsible funds hold. McDonald’s is deemed socially responsible because of its support for children’s charities, participation in recycling programs, hiring and promotion of women and minorities, and purchase of hundreds of millions of dollars in goods and services from woman- and minority-owned businesses.

But how socially responsible is a company whose business depends on beef? It’s certainly not the best for people’s health, and raising cattle is tremendously land and water intensive. Moreover, some may also question the screening and awarding of contracts based on gender and ethnicity. Others may blame McDonald’s for running small local restaurants out of business and contributing to the sterile strip-mall culture of our communities.

Or consider Toys “R” Us, the giant toy retailer and another stock that’s widely held by socially responsible funds for many of the same reasons that McDonald’s is. But this company sells widely criticized violent video games that keep kids away from homework. Thus, some investors might consider Toys “R” Us a socially irresponsible company — and that’s before you consider the heaps of plastic (made from petroleum) and the drive toward overconsumption that the toy industry generates.

Pick any company, put it under a magnifying glass, and you can find practices that are objectionable to somebody’s (perhaps your) moral consciousness. Of course, that’s a poor argument for throwing in the towel. I’m simply warning you that you may be hard-pressed to find a fund manager whose definition of social responsibility is closely enough aligned to yours. A mutual fund, by its very nature, is trying to please thousands of individual investors. That’s a tall order when you throw moral consciousness into the picture.

Even if you can agree on what’s socially irresponsible (such as selling tobacco products), funds aren’t always as clean as you’d think or hope. We live in a global economy where it’s increasingly difficult to define a company’s sphere of influence. Although a socially responsible fund may choose to avoid tobacco manufacturers, it may invest in retailers that sell tobacco products, or the paper supplier to the tobacco manufacturer, or the advertising agency that helps pitch tobacco to consumers.

Ways to express your social concerns

Some funds that aren’t labeled “socially responsible” still meet many investors’ definitions of socially responsible. These other funds usually carry lower fees and produce better returns. For example, GNMA bond funds invest in mortgages that allow people to purchase their own homes. Municipal bond funds buy bonds issued by local governments to fund projects that most would consider good — such as building public transportation, libraries, and schools. See Chapter 10 for my specific bond fund recommendations.

If you consider investing in socially responsible funds, look well beyond a fund’s marketing materials. When you find a socially responsible fund that interests you, call the fund company and ask it to send you a recent report that lists the specific investments that the fund owns. Otherwise, you may be blissfully ignorant, but not as socially responsible as you may like to believe.

You can always consider alternative methods of effecting social change, such as through volunteer work and donations to causes that you support. You can also exercise a means of change that people the world over are dying for, a means that is guaranteed to all U.S. citizens by the Constitution and is exercised today by only a minority of American adults — the right to voice your opinion and vote.