Specialized Funds Can Be Cyclical, Unpredictable
QUESTION: I have seen advertisements for mutual funds that invest in just one type of stock
for example, utilities or technology issues. What are the pros and cons of investing in such a mutual fund?--M. J.
ANSWER: We took your question to several mutual funds authorities, including Reg Green, publisher of the Mutual Fund Newsletter in San Francisco. According to Green, the major benefit--as well as the major downfall--of investing in specialized mutual funds is the inevitable performance cycles of any given industry. Unfortunately, these cycles are not very predictable.
At any one time, Green notes, the stocks in one or more industry groups are performing better--or worse--than the stock market in general. While the reasons for these performances are frequently the result of general economic conditions, they can just as often be tied to something particular to an industry group.
For example, technological breakthroughs, such as a powerful new computer chip or a new wonder drug, can be just the fuel needed to power a surge in technology stocks or biotechnology issues. Falling interest rates are usually sufficient to trigger a run-up in real estate-related issues. Health-care stocks have benefited from the ongoing “graying of America.”
“Bad news” has its effect, too. An obvious example is the performance of energy-related stocks, which have taken a drubbing in recent years as the oil glut has persisted.
A similar glut of office space, particularly in Texas and Florida, has also driven down the price of some real estate investment trusts. But when gluts--whether oil or office space--are absorbed, as they usually are, and prices and rents rise, as they inevitably do, then the commodities are again viewed as a good investment.
Obviously, the most important key to investing in a specialized fund is timing. A successful investor buys into specialized funds when it appears a particular industry is at the bottom of a cycle and then holds the investment until the industry strengthens and finally hits its peak.
Green and others say it’s virtually impossible to gauge the relationship between the cycle of an industry’s overall performance with the cycle of its stock price performance. “If I could tell you that, I would have been a rich man a long time ago,” said one Los Angeles stockbroker.
Once an investor has decided the timing is right to purchase stocks in a particular industry, specialized mutual funds allow him the chance to participate in an overall rise of an industry without the additional headache of deciding which company to back.
For example, in a growing industry such as biotechnology, where only some companies are likely to emerge as big winners, a specialized mutual fund allows the investor to bet on the industry without having to pick a particular “winning” stock.
At the same time, however, a specialized fund can dilute the benefits that an investor could reap if he had picked the top-performing companies in a particular industry. Furthermore, if the industry segment selected by the investor suddenly declines due to unforeseen circumstances, an investor suffers far more than he would in a more broadly invested mutual fund.
“The point is that specialty funds offer greater rewards but greater risks as well,” Green says. Furthermore, he notes that these funds run counter to the basic notion of a mutual fund, which is to spread an investor’s risk over several industries as well as companies.
Still, for those investors interested in specialty funds, Green has several pieces of advice. First off, he recommends that investors put only a small portion of their total portfolio into these funds. Beyond that, he advises that, once the investment it made, it be left alone for at least five years. “The average, non-professional investor should view these funds as a fairly long-term commitment,” he says. “It’s far too risky for the average investor to be actively trading in these shares.”
Q: Recently you said that the “tax basis” for any gift of stock was the price that the donor paid for the shares, plus brokerage fees. However, what is the tax basis in a case where a child inherits stock from a deceased parent? The trading price at the time of death?--A. S.
A: Yes. Generally speaking, the “fair market value”--the closing price on the stock exchange--on the day of the donor’s death is used to establish the tax basis of the shares. (The tax basis is used to determine the amount of tax owed when the shares are sold. The basis is subtracted from the sales price to produce the taxable gain.)
Fair market value on the date of death typically suffices for small and medium-size estates. However, in the case of an estate of more than $600,000, where the Internal Revenue Service requires the filing of an estate tax return, the executor may choose to value the securities either as of the date of death or an “alternate valuation date,” which is generally six months after the donor’s death. For additional information, check IRS Publication 559, “Tax Information for Survivors, Executors and Administrators.”
