Why you should be wary of new ETFs

One of my elementary school teachers used to say that there are no stupid questions.

Judging from the mail I get, she was wrong. Thankfully, I get a lot of smart questions too, and here are some of the best I have received from readers in the last few weeks.

From Pete in Seattle: How long should I wait to buy a new exchange-traded fund?

Answer: I wrote a column recently warning investors away from new ETFs based on new, back-tested indexes. The problem there is that the "past performance" is fictional, more hypothetical than factual. Clearly, any new index concept should be given time - at least a year and probably two - to prove that it works and is better than all of the established index products you can choose from .

While new indexes or strategies can be an issue, asset size for a new fund can be an even bigger concern.

For example, FocusShares opened a suite of funds based on Morningstar Inc. indexes last year; while the funds looked good on paper, they never attracted assets and the firm announced it is shuttering all 15 of them before the end of August.

Even when investors are comfortable with the concept of a new ETF, there's the risk - evident in FocusShares - that the fund sponsor won't stick it out if it can't raise the assets to generate decent fee income.

Companies "give it a try" all the time in ETF Land, so treat newcomers with some wariness until they have $50 million or more in assets and an investment methodology that is proven in real life and not just in some hypothetical past.

From Tom in Fort Worth, Tex.: Bruce Berkowitz has Fairholme Fund on top again. Don't you feel bad for telling investors to get out?

A.: Nope, not at all. Berkowitz is a fund manager with a great long-term record who suffered through a horrible 2011, losing 32 percent and ranking dead last in Morningstar's large-cap value category.

This year, the fund is at the top of that group, having gained almost 25 percent year to date.

Berkowitz's record was never in question; long-term it is one of the best in the business. That record was not really jeopardized by his 2011 troubles; they would have had to continue much longer.

The problem is that as Berkowitz focused the fund more narrowly, it became more volatile and less like the issue most investors wanted when they bought it in the first place. Berkowitz - like all good money managers - was going to stick to his guns, but that doesn't mean investors should be comfortable with the risks he is taking when he's firing.

Bill Miller, the former manager of Legg Mason Value Trust, made his reputation by beating the market for a decade, and then ruined it by using mostly the same strategy - with a few tweaks - when the market changed.

The same could be said for Kenneth Heebner of the CGM Focus fund, whose style has produced results, but with a ride that makes investors seasick.

For investors who feel like they can trust and depend on a fund manager, there is no problem riding out the rough patches. But when a manager starts doing things that create performance surprises - as happened in Berkowitz' case - average investors who think they might be more comfortable elsewhere should make the move.

Once you become uncomfortable with a fund, it is hard to get your comfort back; even investors who rode it out with Berkowitz are questioning whether they can trust that he's "back." Before the drama of his 2011 year, they had no real reason for discomfort.

From William in New London: I don't really want to invest internationally. You've said that people who avoid foreign stocks will still be exposed to what is happening in foreign markets because they own stocks in companies that have a lot of foreign business.

How can I invest if I want pretty much no impact from foreign businesses?

A: That's hard in a global economy, but think small. Obviously, that could be making small purchases into stocks that have no foreign exposure, but the truth is that it probably means looking at small-cap funds.

Unlike large-cap issues where you are buying multi-national giants, many small-cap companies have little or no foreign business (they may still be affected by foreign competition, but that's to be expected in a global marketplace).

Thus, a domestic small-cap fund not only avoids the investments in foreign stocks, but the securities it holds will generate most of their top-line revenues at home.

While a lot of investors would suggest that this kind of thinking misses out on opportunities - economic issues overseas have turned some of the world's best companies into bargains, relatively speaking - the truth is that there are mutual funds or ETFs that will allow investors to pursue almost any strategy. It just may take some digging through fund portfolios or portfolio-screening tools to figure out which funds can do the job you are looking to get done.

Chuck Jaffe is senior columnist for MarketWatch. He can be reached at cjaffe@marketwatch.com.