Should you marry your specialty funds?

Specialty funds can be the most rewarding kind available. But they don’t necessarily stay that way for long. Astute, aggressive investors will recognize this and may move among specialty funds to catch sharp updrafts and avoid the opposite.

If you like to invest in specialty funds, those that concentrate on a single industry or type of company, you might want to think in terms of trading for relatively short-term profits rather than the buy and hold strategy that makes so much sense with diversified funds.

Specialty funds can go through periods of extreme strength, sometimes leading investors to believe diversified funds no longer make sense. But these periods seldom last more than a few years. And when a market segment goes out of style, it can be a painfully long time before it regains investor enthusiasm.

Stock markets go through phases, or trends, as participants like to call them. The most obvious, of course, are bull and bear markets.

But even within bull phases, markets experience internal dynamics that see various industries or types of stocks do well relative to others. These trends tend to last a couple of years. But they can and do change without much warning.

A famous example, of course, is the “technology bubble” of 1997 to 2000 that caused markets to soar worldwide. The tech sector caught the imagination of investors everywhere. And they drove prices of many tech stocks to unrealistically high levels.

Emotion took over

Investors believed tech companies could and would grow from money-losing startups to cash generators in no time. And, based on a few early examples including Microsoft, Nortel and Cisco, investors chased anything from computer makers and sellers to companies with little more than an idea for commerce over the internet.

But all that came to a sudden end in March 2000. Perhaps not coincidentally, the so-called “old economy” stocks — manufacturing and financial services among them — hit bottom as a group at the same time.

Make no mistake, these were emotional, not economic, extremes — highs for tech stocks, and lows for old economy stocks. And investing is an emotional activity.

But a common characteristic of stock trends is that they carry valuations to extremes, in both directions, and then change. The aggressive industry-sector investor will try to recognize trends in progress, ride them until they change and then change his or her investment thesis. The ideal, of course, is to get out of sectors at emotionally-based high valuations and into sectors at emotionally-based low valuations.

The conservative investor will create a diversified portfolio, sure to own some stocks that participate in any trend. And over time, the portfolio will produce respectable returns. Using diversified funds, these investors need not second guess the portfolio managers of the diversified funds.

Any diversified portfolio, of course, won’t keep up with a specialty fund when its particular mandate is popular with investors — trendy, you might say. That’s because by definition, the diversified portfolio will hold stocks not part of the trend. They may even be part of a trend in the opposite direction.

To win at aggressive sector investing with specialty funds, then, you’ll have to recognize a trend early on and invest in a fund that specializes in the stock that characterizes the trend. Then, to do better than the more passive diversified portfolio, you’ll have to get out of the trendy fund near the top, either before or soon after the trend changes.

In other words, with aggressive sector investing, you don’t stay with specialty funds for the long haul.

Easy to say, hard to do

Unfortunately, that’s easy to say but difficult to do. And if you miss a trend, either by getting in too late or by getting out too late, you may have a long wait for your specialty fund to enjoy a bullish trend again.

One sector in which a new trend may be getting underway is the gold sector. Gold-mining stocks experienced three consecutive losing years in 2011, 2012 and 2013. That’s unusual for any sector, and it’s one reason why the recent rally in gold shares may be more than just a flash in the pan.

Indeed, after plummeting by more than 48 per cent last year, the S&P/TSX Global Index has soared nearly 27 per cent this year. Meanwhile, the price of gold is up just roughly 12 per cent year-to-date.

Among the factors that may support a continuation of the gold stock rally is the improved state of gold producers. They have reduced costs, become more efficient capital allocators and rationalized production. They’re, therefore, in a better position now to deliver an acceptable return to investors than was previously the case.

An improved outlook for the yellow metal’s price also bodes well for gold equities. Recent strength in gold suggests that investors are now less fearful of the impact of the U.S. Federal Reserve’s tapering program on the price. Then too, outflows from gold exchange-traded funds have slowed. And physical demand remains strong, while supply growth appears limited.

Of course, gold has also benefitted from its “safe-haven” appeal lately, thanks to tensions in the Ukraine and financial instability in China. A further deterioration in any of these situations would likely boost gold’s safe-haven appeal.

RBC GLOBAL PRECIOUS METALS FUND remains our preferred choice for gold investing.

Recommendation:

RBC Global Precious Metals Fund is a buy for highly risk-tolerant investors who are willing to take a chance that gold equities will continue to rebound.

 

 

Let your winners run

While taking profits can make sense with specialty funds, you will probably always have time to recognize a change in trend. The earlier you get in, of course, the greater will be your gain and hence the more of a decline you can take to be sure you’ve experienced a change. So if you like to trade with specialty funds, concentrate on recognizing trends early and buying low — before trends begin.

 

Canadian Mutual Fund Adviser, MPL Communications Inc.
133 Richmond St.W., Toronto, ON, M5H 3M8. 1-800-804-8846