From the September 2007 issue of Boomer Market Advisor • Subscribe!

Funds that fill a boomer niche

There's a reason CNBC has dubbed Vern Hayden "Mr. Mutual Fund." Mutual funds are Hayden's bread and butter; instruments that have solidified his reputation and his wealth management practice.

While the fund combinations he uses are complex, his fund-selection formula is simple enough to boil down to a football analogy.

"In putting together a portfolio," he explains, "I assemble some for offense, some for defense and some for special teams."

It's in special teams where fund companies have been particularly busy of late, rolling out highly specialized, narrow-purpose, niche-type funds designed to address very specific investor needs. From "AMT-free" funds that help investors avoid the alternative minimum tax to funds whose investment policy is guided by religious doctrine, this product class is customized to appeal to investors of a certain profile. Some are built specifically for tax-efficiency. Others are designed as an inflation hedge and an asset class diversification tool. There are also those angled at people whose investment choices are dictated as much by ethics, personal values and a sense of social responsibility as by the bottom line.

According to Hayden, these special-teams funds -- also referred to as supplemental holding funds -- are proving to be valuable investment tools.

The Winslow Green Growth Fund, a no-load, small-cap fund that currently $400 million invested in renewable energy, natural products, recycling and water management sectors recently earned a five-star overall rating from Morningstar in the small growth category. Lipper has also placed it in the top 1 percent of small-cap growth funds for three- and five-year performance. That performance has earned recognition for the fund and its lead manager, Jack Robinson. Kiplinger's Personal Finance named it the best socially screened fund of 2006, the same year that Barron's /Value Line ranked Robinson number one in the aggressive growth category, and number nine overall in its annual ranking of top fund managers.

Another well-known specialty fund, the Women's Equity Fund, invests in "stocks that advance the social and economic status of women in the workplace." Its largest holdings currently include the likes of Microsoft, 3M, Costco, Nike and Target.

While a number of funds are available that advance legitimate agendas, Hayden warns of companies that have simply repackaged existing products under a new marketing label.

"I think marketing assessments are driving creation of some, but not all, of these types of funds," he says. "Their scope is so narrow that I worry it might compromise the fund's ability to get the most value for investors. Take alternative energy, for example. I'd rather have a really bright fund manager picking one company from that area if he likes [the company] rather than being limited to only picking those kinds of companies."

Divine investing

While some give investors the means to support specific social causes, other specialty funds have a religious bent, one that brings new meaning to the term conservative allocation. The Timothy Plan, which offers eight mutual funds, bluntly states, "If you are concerned with the moral issues (abortion, pornography, anti-family entertainment, non-married lifestyles, alcohol, tobacco and gambling) that are destroying children and families you have come to the right place."

Some Timothy Plan funds, including the Strategic Growth A fund, rate below-average overall; others earn an above-average overall rating from Morningstar, including its Large/Mid-Cap Value A fund, which gets a four-star rating. That fund's largest holdings include energy companies, ExxonMobil and Marathon Oil, an indication the Timothy Plan isn't averse to holding stocks that green funds typically avoid.

Need tax relief?

Social and ethical concerns aside, there are plenty of special-purpose funds designed for people who are oriented toward the bottom line. In particular, fund companies are focusing on developing tax-friendly and income-oriented funds, some of which have relatively narrow applications.

Besides offering a family of municipal bond funds -- the Rochester family -- to provide tax-exempt income to investors in 15 states, OppenheimerFunds also has the AMT-Free Municipals fund. It's an income-focused fund built to provide investors with tax relief by investing in bonds that are exempt from the AMT and other federal income taxes.

The proliferation of AMT-free funds is largely due to recent tax code changes, which have made AMT more of a concern for investors, according to Tom Keffer, senior vice president and director of product management at OppenheimerFunds. "It went from being a technicality to something that was creeping up on a lot of people."

If a tax issue is drawing significant public attention, there's probably a niche-type mutual fund available to address it. Funds with a return-of-capital feature fall into this category. Parts of their distributions are made up of the investor's original principal, rather than taxable income. While taxes will eventually have to be paid on potential capital gains upon sale of fund shares, distributions under the ROC structure carry tax-deferred status, creating additional near-term income for the investor whose priority is immediate cash flow. TD Mutual Funds is among several providers recently to introduce an ROC fund, the TD Corporate Bond Capital Yield Fund.

Hayden says that the growing emphasis fund companies are placing on special-purpose, tax-efficient funds plays into the hands of advisors, who more than ever are being asked by clients to find new ways to overcome burdensome tax challenges. "Overall I'm more sensitive to the tax issue today and so are many of my clients, and I think because of that, fund companies have increased their sensitivity to the issue."

In creating specialty funds, companies walk a fine line between catering to targeted market segments and developing products that circumstances may later render obsolete.

"The hard thing is where to draw the line," says Keffer. "What happens if that wrinkle in the tax code goes away? The challenge from the product-development point-of-view is that you don't want to put a huge effort toward addressing some anomaly that [may be] short-lived."

Fund companies also are wary of confusing investors.

"Space in our product line is precious," Keffer concludes. "We're trying to avoid a proliferation of the product line to the point of confusion. We want to avoid things that are too narrow in scope or short-lived in their application."

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