Worthwhile Picks in Weak Fund Categories

NEW YORK (TheStreet) - Any investment can suffer occasional off years. But several categories of mutual funds have disappointed investors again and again, delivering subpar results over the long term and failing to achieve their goals.

The poor performers include high-yield municipals, market neutral, and commodities funds. Should you avoid the weak categories altogether? Some advisors think so. But by shopping carefully, it is possible to find a handful of funds in the categories that are worth owning.

Consider high-yield municipal funds. Low-quality bonds have been crushed in downturns. When the market collapsed in 2008, the category lost 25.3%, according to Morningstar. That was a shocking result for a fixed-income category. Last fall, the high-yield municipals again gushed red ink. Weighed down by the losses, the high-yield tax-free funds only returned 1.0% annually during the past five years, compared to 3.4% for intermediate-term national municipal funds, which focus on high-quality issues.

Long-suffering shareholders in high-yield municipal funds may not get any relief soon because some kinds of municipals are being hurt by persistent problems. Among the shakiest issues have been so-called dirt bonds, which were issued to finance development of single-family houses in Florida and other states. When the housing markets collapsed, so did the bonds -- and rebounds are not likely for years to come.

Other troubled issues are tobacco bonds. These were created after cigarette makers --including the predecessors of Altria ( MO) and Lorillard ( LO) -- agreed to pay 46 states $200 billion over 25 years.

States such as Ohio and Illinois issued $56 billion worth of municipal bonds backed by revenues from the cigarette companies. But in 2009, sales of cigarettes dropped by 9%. As a result, the risks of bond defaults are greater, and the tobacco bonds have sunk. Now some analysts worry that cigarette sales will continue falling for years as more smokers quit because of health concerns or the rising costs of the habit.

To get higher yields while avoiding most tobacco and dirt bonds, consider Franklin High Yield Tax-Free Income ( FRHIX), which has returned 3.1% annually during the past five years.

To protect shareholders, the portfolio managers hold a big stake in investment-grade issues. They juice up the yield by holding some lower-quality bonds backed by hospitals and industrial projects that seem likely to deliver reliable interest payments.

Another disappointing category has been market-neutral funds. These own stocks and an equal amount of short positions, which record profits if stocks drop. The idea is to deliver modest returns almost every year. In a rising market, the longs should score gains and outdo the shorts, resulting in small gains for shareholders.

When stocks drop, the shorts should offset losses and help the funds to stay in the black. But the funds have suffered losses in up and down markets, recording small declines in 2008 and during the recovery in 2009. Most investors would be better served by holding short-term bond funds, which returned 3.8% annually during the past five years, compared to a return of 1.1% for market-neutral funds.

One fund that has beaten the average is JPMorgan Research Market Neutral ( JMNAX), which has returned 4.1% annually during the past five years. The fund could provide important diversification, because it has very low risk scores and doesn't track either stocks or bonds.

Among the biggest disappointments lately have been commodity funds. During the past five years, broad-based commodity funds have lost 1.7% annually. Part of the decline can be traced to 2008 when commodity prices collapsed. But there has been an additional problem caused by the peculiar conditions in the markets.

Many of the funds own futures, not the actual commodities. In a typical strategy, a fund buys a one-month futures contract based on the price of oil. As the end of the month approaches, the fund sells the contract and buys a new one for the next month. Because many funds sell contracts on the same days, the prices of the old contracts can be depressed, while new contracts are bid to higher prices. So a fund may sell a contract based on oil at $90 a barrel and buy one at $92. When that happens, the fund loses money on the trade. The condition is known as contango.

To appreciate how powerful contango can be, consider that oil prices today are about where they were three years ago. But during that period, United State Oil ( USO), which buys crude futures, has lost 19.9% annually. Most of the red ink can be attributed to contango.

To limit the risk of contango, try Eaton Vance Commodity Strategy ( EACSX), an actively managed fund that aims to beat a commodity benchmark by a few percentage points annually. Portfolio manager John Brynjolfsson seeks to trade on days when contango is less pronounced. "If many investors are trading at the same time, then that may not be the best time to trade," he says.

A new fund that seeks to minimize the impact of contango is Van Eck CM Commodity Index ( CMCAX). The fund tracks an index that holds a mix of contracts with different maturities. That way shareholders will not be unduly penalized if the price of one futures contract is severely depressed.

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Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.

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