If you’re a product manager at a fund company, you probably spend a lot of time thinking about what types of new products you want to bring to market. While the total number of mutual funds and exchange-traded funds has remained relatively constant over the past decade, new funds continue to enter the market as older funds are merged or liquidated. As a result, the fund mix available to individual investors is constantly evolving as fund companies introduce new products to meet expected demand.
But not every trendy area for newly launched funds is worth investing in. In this article, I will look at some of the most popular areas for fund launches recently and give my opinion on their investment value.
What’s hot?
The chart below shows five of the most popular Morningstar categories based on growth in the number of funds over the past few years (including multiple share classes). The growth rate represents the net change in the number of funds, as the total each year includes existing funds plus newly launched funds, less any merged or liquidated funds.
Source: Morningstar Direct. Data as of August 31, 2023.
I have already written about the fund industry’s tendency to bring more and more special funds onto the market. This trend shows no signs of changing: Three of the five fastest-growing categories are more specialized categories that most investors probably don’t need. With that generalization out of the way, here’s more detail on the top five areas, as well as my opinion on whether each one is worth investing in.
Digital assets
The digital asset category is relatively new; Morningstar only added it as a separate category in April 2022. To qualify for inclusion, funds in this category must have a significant portion of their risk coming from digital assets. Digital asset portfolios invest the majority of their assets in one or more areas broadly classified as decentralized finance, stablecoins, currency investments, smart contracts platforms, exchange investments, privacy investments, yield farming, and non-fungible tokens, among others.
The category has grown explosively in recent years and is by far the most popular area for launching new funds. There were 13 crypto-related funds at the end of 2020, but by the end of 2022 that number has more than tripled. The group now includes a diverse selection of crypto-related funds, ranging from single coin offerings to broader plays with companies leveraging digital assets. Cryptocurrencies are generally highly speculative, but in many cases the newly launched digital asset funds have been even more volatile and have produced lower returns than investors would earn by simply purchasing major cryptocurrencies directly.
The Verdict: Most investors should proceed or handle this with extreme caution.
Target date 2065+
There is nothing controversial or playful about this category. Like other target funds, funds in this category offer diversified exposure to stocks, bonds and cash for investors who have a specific retirement date in mind (in this case, around 2065 and beyond). The goal of these portfolios is to provide investors with appropriate levels of risk and reward based on the target date. Management adjusts the asset mix to become more conservative as the target date approaches, following a preset glide path.
The large number of funds launched in this category reflects both demographic trends (as Millennials are now old enough to start saving for retirement) and the growing popularity of target funds. Under the Pension Protection Act of 2006, retirement plan sponsors can now use target funds (as well as managed retirement accounts) as qualified standard investment alternatives (QDIAs). Target funds are becoming increasingly popular: 98% of plans that partner with Vanguard as recordkeeper and identify a QDIA offer target funds as a default investment option.
Target funds are solid investment options because they offer built-in portfolio diversification that automatically adjusts to become more conservative as shareholders approach retirement age. Because target date funds are complete packages, they eliminate most of the guesswork and potential pitfalls that investors would face when trying to build their own retirement portfolio.
The bottom line: These funds are a good choice for millennials saving for retirement in a tax-advantaged account.
Options trading
Options trading strategies utilize a variety of options trades, including put writing, options spreads, options-based hedged stocks and collar strategies, and others. Some funds in this category also engage in options writing to generate a portion of their returns. They often use options strategies to reduce volatility and/or downside risk.
The number of funds in this category has almost doubled since the end of 2020. Most of the growth has come from results-oriented ETFs, also known as buffer funds. These funds promise to provide downside protection below a certain level over a predetermined outcome period. To do this, they employ options strategies on an underlying stock index (often the S&P 500) to limit losses while providing some upside returns.
Most of these funds have so far kept their promises. For example, the average buffer fund limited bear market losses to about 9% in 2022. However, options trading funds are relatively expensive because they are essentially index funds with an options overlay. Investors should also be aware that they must accept significant upside potential in exchange for limiting losses. Most of these funds only offer investors price gains on the underlying index and forego dividend income.
The Verdict: Not a bad option for investors willing to give up some gains in exchange for limited losses.
Derivative income
Derivative income strategies primarily utilize an options overlay to generate income while maintaining significant exposure to stock market risk. They typically earn income by writing covered calls. While they still have some equity exposure, they typically have below-average betas compared to broad stock market benchmarks.
If you’ve been investing in funds for a long time, these funds probably look familiar to you. They are options funds with a slightly different twist. In the late 1980s, options funds that invested in government bonds were all the rage. However, like their predecessors, today’s derivative funds have two major drawbacks. Your “income” is actually short-term capital gains, which are typically taxed at higher rates compared to stock dividends. They also forego significant return potential in exchange for lower volatility. Additionally, derivative income funds are relatively expensive, with an average expense ratio of around 1.00%.
The Verdict: Probably not worth the hype.
Ammunition target readiness
Target maturity muni funds typically invest in bonds from various state and local governments to finance public projects. Income from these bonds is generally free of federal taxes and may be exempt from state and local taxes for investors who reside in the same location as the issuer. Unlike other municipal bond funds, which typically invest in bonds with varying maturity dates, municipal bond funds invest in bonds with a set maturity date. When the fund reaches its target maturity date, it returns cash to investors.
These funds can be useful for investors who want to allocate cash flows from their investments to a specific date, such as paying for a wedding, a child’s college education, or a down payment on a house. Retirees could use these funds to build a wealth ladder with increasing maturity dates to meet their retirement cash flow needs. Investors can also achieve this active-liability matching by purchasing a single bond, although this would involve higher issuer-specific risk and higher transaction costs.
The bottom line: These funds are a solid choice that can fill a practical need for many investors.
Diploma
The areas highlighted above are just a small selection of new funds that have launched in recent years. But the patterns are telling: At least three of the five categories represent highly specialized areas that I would personally avoid. If you see a number of new funds launching in an area that has been performing strongly recently, it’s worth being skeptical.
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