PowerShares Lux Nanotech fund

Roger D. from Salem, Mass., has been reading and hearing a lot about nanotechnology, and figures it's "America's next great investment sector."

Hoping to "get in on the ground floor," he wrote recently looking for a mutual fund that specializes in nanotech.

There is one, but the PowerShares Lux Nanotech fund, an exchange-traded fund, won't give Roger what he wants because it's a Stupid Investment of the Week.

It's not that nanotechnology is a bad business, or that exchanged-traded funds are a poor idea. It's that the combination of the two, at this point in time, can't deliver what investors like Roger really want, namely an intense focus on this emerging technology.

Stupid Investment of the Week highlights the flaws and characteristics that make an investment less than ideal for the average investor, in the hope that spotlighting problems in one situation will make them easier to root out elsewhere.

While obviously not a purchase recommendation, neither is this column intended as an automatic sell signal, as there may be times when unloading a problem investment merely compounds trouble.

PowerShares Lux Nanotech (ticker PXN) was up nearly 15 percent in its first two months. That rapid gain is what investors like Roger might expect from a nanotech fund; it helps hide the fundamental problems in the fund.

To see those concerns, we must first examine the investment's basic underpinnings.

Nanotechnology — sometimes called "molecular manufacturing" — is more about process than product.

Where "biotechnology" focuses on specific techniques, nanotech is a branch of engineering working at the molecular level to effect change in the design and manufacture of goods. It has uses in countless products.

Functionally, nanotech is not so much an industry or sector, as it is a foundation for development, kind of like electricity. It already is part of many everyday goods and eventually will be pervasive; today, however, it is still a developing field in which many different companies are doing research and development to come up with ways to improve what they do.

Lux Research is the leading nanotech consulting and advisory firm, and the creator of the Lux Nanotech Index, which tracks 26 public companies involved in "developing, manufacturing and funding nanotechnology operations."

PowerShares is a leading provider of exchange-traded funds, which effectively are baskets of stocks that are put together to track a benchmark just like an index fund, but which trade minute-by-minute like a stock. Exchange-traded funds can be a cost-effective and flexible way to capture all of the benefits of index investing.

But when you put the ETF structure together with a thin index like Lux Nanotech, what you really get is a muddle.

The first clue is the 26 companies, making the index even tighter than the Dow Jones industrial average with its 30 stocks, and barely diversified on its face. When a sector is this narrow, it's hard to construct an index that can be used as the basis for an investment.

During the Internet stock mania of the late 1990s, investment firms rushed to create "Internet funds," but built portfolios holding just about any company with a Web site.

Eventually, to differentiate companies building the Internet from stocks like Gap that simply used the Net as another distribution channel, "pure-play funds" emerged, focused only on the firms developing the new technologies.

An investor like Roger wants pure-play on nanotech, and the PowerShares fund falls short.

You'd be hard-pressed to find anyone who considers General Motors to be a "nanotech stock," and yet it makes up nearly 2 percent of the index, and thus the fund. The same goes for General Electric (GE), duPont (DD), 3M (MMM), IBM (IBM) and Hewlett-Packard (HPQ).

And yet stocks like that make up 25 percent of PowerShares Lux Nanotech.

Clearly, the name-brand companies use nanotechnology at one level or another, but it's not yet grown to where it's a major component in bottom-line profits.

If interest rates and gas prices shoot up dramatically next year and new car buying slows to a crawl, nanotech may help GM develop some innovative new products, but it won't save the company's bacon.

Meanwhile, stocks where nanotech is the primary business make up less than half of PowerShares Lux Nanotech.

"Pure-play nanotech would be difficult to do today," says PowerShares CEO Bruce Bond. "We'd be concerned about knowing the viability of those companies. The big names in the fund are the companies that are spending the most on nano-enabled products in their businesses today, and they are the ones that have the most to gain as nanotechnology and research is made available."

There are two other key reasons for allowing blue-chip dilution. First, there's that questionable viability of pure nanotech stocks, as described by Bond. And then there is liquidity; having some giants in the line-up ensures the kind of liquidity necessary to run a fund based on an index.

Matthew Nordan, vice president of research at Lux, notes that it would be intellectually dishonest to build the index without including the giant companies that, to date, have benefited most from nanotechnology, and he's probably right.

But it would be equally dishonest to sell a guy like Roger a nanotech fund that doesn't give him much real exposure to the small, emerging issues that he actually wants to own.

If GM, 3M and the others are nanotech stocks, then investors like Roger get their fill of nano through ordinary growth mutual funds.

"I don't think you can look at this and think you really are buying a true nanotech fund," says Jim Lowell, editor of the ETF Trader newsletter, also published by MarketWatch. "Yes, these big companies are very interested in using and developing nanotechnology, but it's a research and development expense to them, not a profit center.

"When an ETF cannot hold what its name says it holds, but instead reaches out to get stuff that doesn't belong, you're looking at a gimmick. Average investors usually are better off avoiding gimmicks."

Chuck Jaffe is senior columnist for MarketWatch. If you have a suggestion for Stupid Investment of the Week — or a comment about this week's column — you can reach him at jaffe@marketwatch or Box 70, Cohasset, MA 02025-0070.