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Be cautious when buying a newly created fund


EVERY NEW mutual fund, if you believe the firm creating it, combines management's unique vision with a part of the market worth investing in.

Where hype makes a fund intriguing, "newness" makes it difficult to evaluate.

That's why investors must be particularly cautious before buying a newly created fund.

The odds are slim that such a fund becomes a huge long-term winner, able to weather the market's storms to become a portfolio cornerstone.

Statistically speaking, at least half of all new funds should do no better than average over the long haul.

So if you are considering a new fund or you hear about an issue that sounds interesting, delve deeply into the logic behind it before you invest.

New funds that get the most ink tend to be doing something outrageous.

But with fund firms rolling out new products every day - nearly three funds per day last year - the majority of new issues are the same old things, not unlike a store or restaurant that's "under new management."

Industry watchers point to a "new fund phenomenon," in which these issues tend to outperform established ones during the earliest stages as they gather assets.

That trend doesn't apply to all funds, so an investor needs to size up each new issue on its own merits. "New" does not necessarily mean "improved" from what you own now.

To see the logic that investors should apply to new funds, let's consider Capstone Employee Stock Ownership fund, opened last month by Houston-based Capstone Asset Management Co.

The fund seeks "long-term capital appreciation by investing primarily in U.S. companies with broad-based employee stock ownership plans."

That's the "hook." Academic research shows that employees who hold stock are committed to the success of their company, and that firms using stock to develop committed workers tend to do better financially than firms that don't encourage employee ownership.

As Capstone President Dan Watson explains it: "The interest of investors and employees are aligned through stock ownership, which tends to produce above-average return on assets and operating numbers."

There's the persuasive argument from management, but let's keep digging.

Capstone looks for firms where company stock is available to at least 50 percent of workers through employee stock ownership, retirement, stock bonus and stock option plans. The fund will hold 60 to 80 stocks of the 600-plus meeting the stock ownership screen.

That screen is unique, but the process is not much different from the social filters used by managers who want to avoid anything from companies that pollute to those whose activities violate specific religious tenets.

By itself, the screen is no guarantee that the fund will buy great stocks. After all, Capstone's Houston neighbor Enron Corp. would qualify.

So would distressed companies such as Kmart Corp. and Polaroid Corp. (Capstone's timing for this new fund is unintentional but unfortunate given news on how employee stockholders at those firms suffered due to corporate problems.)

That those losers survive the screening process doesn't invalidate the concept, it simply points out the obvious: This fund will live or die based on management's ability to pick winners.

In other words, this fund isn't all that different after all.

Where some fund managers use growth rate or debt load or some technical indicator as a primary selection criteria, Capstone will cut the universe using the stock-ownership screen, then apply its normal stock-picking process to the companies that survive.

When a new issue proves not-so-revolutionary - almost all are quite ordinary beneath the surface - the selling point becomes faith in management at least as much as the new concept.

In Capstone's case, the firm's existing funds have low costs, which is good, but tend to deliver average to just-above-average returns in their peer groups, as measured by Morningstar Inc.

That's not too inspirational.

The next concern with a new fund is need, as in, "Do I need a fund that does this?"

The Capstone fund most likely will fall into the "large-cap blend" category, buying mostly big-name stocks and combining both value and growth investment styles.

When a new fund overlaps with something you already own, you certainly don't need to complicate your holdings and invest with it. If the fund has some twist to make it unique and you want to take a flier, make sure it's a small percentage of your assets - less than 5 percent - until the fund proves itself.

As Corey Rosen, executive director of the National Center for Employee Ownership noted about Capstone: "The research is on their side, but it still comes down to whether they are picking and choosing wisely from their universe of stocks. ... It's not much different from any other new fund, in that it'll take some time before we know that."

Chuck Jaffe is mutual funds columnist at The Boston Globe. He can be reached by e-mail at or at The Boston Globe, Box 2378, Boston, Mass. 02107-2378.

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