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5 Funds That Don’t Exist, but Should

Morningstar logo Morningstar 9/15/2017 John Rekenthaler

Globe on financial documents© Artur Marciniec/Getty Images Globe on financial documents

I know, I know. There are already far more U.S. mutual funds, exchange-traded funds, and closed-end funds than listed stocks. If you purchased one fund each business day, you'd either expire before exhausting the current crop, or you're this column's lone teen-age reader. (Although come to think of it, I once met a 21-year old Australian while on vacation who knew of this report … strange that.) Who on earth would want more?

Good question. Let's just say that if the industry added these options, and eliminated 100 unnecessary offerings for each arrival, the world would contain 495 fewer funds and be better off for the exchange. 

These five proposed funds aren't for everybody, but they are for somebody. Many existing funds cannot make the same claim, being either high-expense duplicates of cheaper substitutes, or gimmicky offerings that encourage their investors to buy high and sell low. 

My prerequisites when assembling this list:

1) Broadly diversified funds

By and large, specialized funds are created when the marketing department outvotes the investment team. Although I do like the idea of targeted ETFs—that is, low-cost, transparent funds that carry concentrated portfolios, such as owning the stock market's 25 cheapest stocks—but I will refrain from adding more clutter to an already crowded field. 

2) No alternative strategies

See above. Over the past decade, a host of “alternative” funds have been launched, many of which can short the market and/or use options. As with specialized funds, most have relatively high expenses and haven't performed very well. This group, too, could benefit from the launch of some cheaper and more transparent funds. Once again, I will refrain. 

3) Passive investment approaches

Advocating new actively managed funds is assuming the ladder. Identifying a winning actively run fund before it is even launched lies rather beyond my capabilities.

Tax Matters

The first proposal, made by Morningstar Analyst George Georgiev, is dual, and relates to taxes. Georgiev advocates splitting market-cap-weighted stock indexes—his recommendation is for the U.S. broad market, but the principle also applies to narrower U.S. indexes, as well as to international benchmarks—into two funds. The first fund would hold all stocks that do not pay dividends, and the second would hold all those that do. 

We'll call those funds U.S. Stock Market Taxable Account and U.S. Stock Market Tax-Sheltered Account. Their uses are directly indicated by their names. The first fund, which will not make any income distributions whatsoever, is to be placed in an investor's taxable account, while the second will go into her tax-sheltered accounts. If the shareholder splits her assets proportionately between the two funds (that is, according to the percentage of the stock market that each index represents), then she will likely be better off than if she had used a single, overall index for each account. 

(That last statement does require a hedge, because tax math can get messy depending upon the assumptions, but the general rule applies: Time is money. Better, for the most part, to defer taxes and pay them later, than to pay upfront today.) 

This pair of funds isn't for those who have but a single type of account. Those with only tax-sheltered assets need not worry about paying taxes on income distributions, while those with only taxable assets would be unwise to focus so much on avoiding such distributions so as to skew their portfolios by avoiding a large market segment. (Neglecting Google, erm  Alphabet GOOG, would have been a painful mistake.) But that still leaves plenty of investors who have monies in both places, and who be served well by the funds' tax split.

The Closed-End Advantage

Morningstar's Kevin McDevitt also envisions splitting market indexes, but in a different fashion. As McDevitt points out, closed-end funds have a major investment advantage over both traditional mutual funds and ETFs: They are never troubled by redemptions. No closed-end fund is ever forced to sell its securities so as to raise cash. Thus, while mutual funds and ETFs must hold portfolios that are sufficiently liquid, closed-end funds have no such concern.

So, if caution is not required, why not throw it to the wind? We know that, all things being equal, investors would rather own securities that can be easily traded than those that cannot—which, all else being equal, means that illiquid securities have higher expected returns (to compensate for their undesirable attribute). So, use the closed-end fund structure to best advantage. Identify the least-liquid issues in a market index, and put them into a closed-end fund. 

This would be the Illiquid Securities Fund. Unlike with Georgiev's suggestion, there would be no companion fund. The liquid securities fund is unnecessary; it already exists, in the form of the standard market-index funds. 

The World Portfolio (Home Version)

As discussed in this column two weeks back, there are neither good theoretical nor practical reasons to own the market-capitalization weighted version of the world stock portfolio. Currently, the United States makes up about half of world equity assets. For domestic investors to emulate that position by placing 50% of their stock monies in foreign securities … acceptable, if that's what you want to do. But it is not required. Nor it is much desired, given how many more assets reside in domestic-stock funds as opposed to international funds. 

My suggestion: World Stock Portfolio, U.S. Version. This fund would index the global stock markets, but would be adjusted to represent U.S. investors' preference (both logical and illogical) for home-cooked securities. The split between U.S. and non-U.S. stocks would necessarily be arbitrary. Seventy/thirty seems as a good a figure as any. Then, within those two groupings, stocks would be weighted according to their actual values. 

I won't attempt to argue that 70% in U.S. stocks, 30% overseas is the ideal investment policy. All I will claim is that it is no worse than any other proposal. And that while some domestic investors will be happy with  Vanguard Total World Stock Index Fund's VTWSX allocations, others will seek a different solution. 

Workplace Diversification

My final proposition consists of several potential funds, which I will consider as one for this commentary. It is the Workplace Diversification Fund. Investment theory—and diligent investment advisors, if they have not tired of beating their heads against the wall—instructs employees to own anything but company stock. Not only should they avoid it, so as to diversify their investment risk from their employment risk, but they should also shun other firms that operate in the same industry. 

These funds would accomplish the task for investors. The technology version of the fund would hold the U.S. stock market index, except that the technology stocks would be removed (or perhaps reduced to a half weighting; the details can be argued). The energy version would operate similarly, as would the healthcare version, and whatever other industry versions were created.  Mass customization, as they say. 

There is one flaw to the idea: Nobody would buy these funds. Far from seeking workplace diversification, investors tend to flock toward company and industry stocks, for the pleasure of investing in what they believe they know. (Your author is no exception to the general rule, although as previously explained, his motivation was somewhat different.) A mutual fund product manager, I would not make. 

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.


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