Several years back, fund companies had a problem; like mall shoppers cruising for parking the day after Thanksgiving, they found all the good spots already taken. All sane investments already existed in fund form. But companies felt they needed variety to lure customers. So they started pushing less-than-sane investments. Today, you can load your portfolio with such funds as the Direxion Daily South Korea Bear 3x Shares or the Global X Fertilizers/Potash ETF.
These are examples of niche funds, says John Rekenthaler, vice president of research at Morningstar. So are the iPath Pure Beta Cocoa ETN and the Guggenheim China Real Estate fund. “These are terrible investments,” says Rekenthaler. “Niche funds may invest in companies from a part of the world you didn’t know had companies, or an industry that you barely knew existed, or both. These are tiny slivers of the global stock market.”
Slivers offer little diversification. The Global X Central Asia & Mongolia fund, for example, is more than 70 percent invested in 10 companies, as is the Global X FTSE Argentina 20 ETF. By contrast, the Vanguard Mid-cap Index Admiral fund has but 6.5 percent of its money in the top 10 companies. The companies that niche funds invest in are not only few, but often pint-sized. Their stock prices may be very jumpy. In addition, niche funds are pricey. Examples mentioned above have net expense ratios of 0.6 to 1 percent. In contrast, the Vanguard fund has an expense ratio of 0.1.
Niche funds aren’t the only terrible investments in town.
Closet Index Funds. An index fund tracks an index. There’s little management involved, and they tend to be very inexpensive. The Schwab S&P 500 Index fund charges 0.09 percent. Then there are closet index funds, such as American Century Fundamental Equity C Shares—expense ratio of 2.01 percent. These are “managed” funds that similarly track the S&P 500—but secretly. “The managers hug the index benchmarks, and if a fund’s returns fall below the benchmark, the manager loses clout. So he plays it safe and easy, mimicking the index, so the fund can’t fall far behind,” says Rekenthaler. “Why bother? Buy a real index fund.”
Equity-Indexed Annuities. A fixed annuity provides a steady sum every month. An equity-indexed annuity (EIA) gives you a monthly sum linked to stock-market performance. EIAs do have one advantage over direct stock investing; the value can only drop so much. The salesmen who sell these, however, often gloss over the finer details, namely that EIAs typically charge high fees. Additionally, “Many do not include dividends when calculating the performance of the index to which payments are tied; the disclosures are opaque, and there are long surrender periods with high charges,” says Barbara Roper, director of investor protection for the Consumer Federation of America. “These products are typically sold by insurance agents who don’t have a legal obligation to act in investors’ best interest.”
A Variable Annuity in an IRA. Variable annuities (VAs) are typically sold years before you take payments, during which time, the VA may grow by investing in stocks, bonds, or both. All growth is tax-deferred, just like in an IRA. That is the big advantage of VAs, which makes them, sometimes, a reasonable investment for someone young, who can defer withdrawals for many years, and someone with high income, who has already reached the IRA contribution limits. The main disadvantage is that the costs of VAs (industry average 2.28 percent) are much greater than most stock or bond funds. “Buy a variable annuity in an IRA, and you wind up paying high fees for no reason whatsoever. IRA money is already tax-deferred,” points out Helaine Olen, author of Pound Foolish: Exposing the Dark Side of the Personal Finance Industry. “Anyone selling you a VA in an IRA is following his own best interest, not yours.”