Specialized Funds Retain Their Appeal Despite Recent Skid

Bad news has been coming in bunches lately for specialized mutual funds that concentrate their investments in a single industry, state, country or region of the world.

The plunge in Mexico’s financial markets has knocked many Latin American and “emerging markets” funds for a loop.

That came hard on the heels of the bankruptcy filing in early December by Orange County, Calif., which rocked the large population of California municipal bond funds.

Meanwhile, year-end data from Lipper Analytical Services Inc. show that seven out of nine categories of sector stock funds, running the gamut from precious metals to utilities, lost money in 1994.

The lesson in all this is simple, says Richard Graber, senior vice president of the Jones & Babson funds in Kansas City: “Diversify. Singlecountry funds, sector funds and single-state municipal funds are too concentrated to avoid sharp losses from direct hits such as those last year.”

Indeed, it’s easy to argue that whenever any fund sets out to specialize, it tempts the financial fates by abandoning a basic principle: The fund industry has succeeded precisely because it can offer investors a degree of diversification those individuals can’t hope to achieve on their own.

But in the face of all this, specialized funds retain a big following, and their numbers are still increasing steadily. For instance, at least two funds are being organized to invest in Russian companies, with all the risk and volatility that fledgling market entails.

Also, several large fund families are bringing out new “emerging markets” funds of both the stock and bond variety, right in the midst of the storms that have hit those markets.

The problem that has arisen repeatedly with specialized funds, notes Steve Savage, editor of the Value Line Mutual Fund Survey, is that “naive investors tend to scurry like lemmings to the latest hot fund.

“Our reactive investor is likely to be disappointed, because last period’s hot-performing funds are often next period’s duds.”

Nevertheless, Savage says, “a broad-brush condemnation of all specialized funds is not deserved.”

In the fiveyear period ended Dec. 31, he reports, seven of the 10 topperforming individual funds were specialized funds. In the last 10 years, they accounted for six of the 10 best. So the evidence shows that they can achieve strong long-term performance, not just flash-in-the-pan moments of glory.

You don’t have much chance to pick one of these long-term winners, Savage asserts, if you buy what looks most alluring at the moment because of its recent performance.

You have a better shot, he suggests, if you start with a “top down” approach.

“First,” he says, “identify a particular industry or, in the case of foreign funds, a particular country or region that you think has attractive prospects, not only over the next year but also over the longer term. Once you decide on particular sectors of interest, you can identify funds that concentrate in them.”

Keep in mind that both short-term volatility and long-term risk can be high, but the potential rewards of specialized funds may be great as well.

Concludes Savage: “Investors who select the fund because they like the sector or the foreign country or region will likely fare a lot better than those who select the fund because they like its recent outsized return.”