Mutual Funds
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2 standout mutual funds that shun risk
Forget what many say -- stocks remain in a bear market, which means aggressive funds are losers. But mutual funds that go for conservative stocks are beating the market.
By Timothy Middleton
Dont take chances, stupid.
Thats what securities markets are telling investors -- and the wise ones listen. Six of the 10 largest mutual funds are beating the Standard & Poor's 500 ($INX) this year, and four of them are doing it with much less risk than the market.
Conservative funds are outperforming their more volatile counterparts, says Doug Fabian, editor of the Successful Investing newsletter. Ordinarily an economic recovery would favor aggressive investments, he says, but this is no ordinary uptrend.
Oil prices are high, battering industries like transportation and draining drivers dollars. The dollar is low, pummeling imports. Employment is lurching higher rather than easing up smoothly. And securities markets are still in the paws of the bear, displaying classic bear-market rallies like that of 2003 amid long-term side-winding like much of 2004.
So even the funds that have accepted the markets level of risk, and yet beaten it, have done so with conservative strategies that include holding high levels of cash. The lesson of all these strategies is this: The current environment is a low-return world in which single-digit gains are the new norm. This in turn means securities that deliver reliable single-digit returns, such as bonds and stodgy dividend-paying stocks, are the most rewarding places to be, as well as the safest.
Validated foresight
Market seers like Warren Buffett have been saying this for five years, and their foresight has been amply validated. Even after last years big run-up, the S&P 500 is more than 20% below its level in the spring of 2000. This is a secular bear market, and its going to be around awhile.
More on mutual funds
Look at your portfolio. If youre banking on Google (GOOG, news, msgs) and other highfliers for success, you may not have very much to deposit. They look swell today, but bull spurts in a secular bear market arent called sucker rallies for nothing.
Heres how the 10 largest mutual funds have fared this year:
| 10 largest funds | | Fund | YTD perf. | 3-year standard deviation | | American Funds EuroPacific (AEPGX) | 15.1% | 15.57% | | Dodge & Cox Stock (DODGX) | 14.7 | 16.39 | | Fidelity Contrafund (FCNTX) | 12.1 | 10.71 | | American Funds Income Fund (AMECX) | 10 | 9.83 | | American Funds Growth Fund (AGTHX) | 8.6 | 17.17 | | American Funds Invest Co of America (AIVSX) | 7.4 | 13.77 | | Vanguard 500 Index (VFINX) | 7.1 | 15.96 | | American Funds Washington Mutual (AWSHX) | 6.9 | 14.61 | | Pimco Total Return (PTTRX) | 4.4 | 4.74 | | Fidelity Magellan (FMAGX) | 4.3 | 15.61 |
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Note: As of 11/30/2004
Source: Morningstar Inc.
In this table, risk is measured in terms of standard deviation, or price volatility. Statisticians have numerous ways of defining investment risk, but losses are the easiest to understand. A fund that can go down in price 15.96% in the average year, as Vanguard 500 (VFINX) (a pure representative of the S&P 500) can, is obviously riskier than one whose downside is 10.71%, as is the case for Fidelity Contrafund (FCNTX).
Fidelity Contrafund is one of two funds that leap off this page in terms of the contrast between lower risk and higher reward. The other is American Funds Income Fund of America (AMECX). Each sports about a third less risk than the S&P, and each is outperforming by a third or more.
Turning to cash
Fidelity Contrafund: Managed for more than 14 years by William Danoff, one of Fidelitys star managers, this fund holds its biggest stake in cash, at more than 10% of assets. The balance is held mainly in domestic companies in boring industries like consumer and industrial products and insurance.
| Top 10 Contrafund holdings | | Stock positions as of 9/30/2004 | | | Avon Products (AVP, news, msgs) | Berkshire Hathaway (BRK.A, news, msgs) | | 3M (MMM, news, msgs) | EnCana (ECA, news, msgs) | | Yahoo! (YHOO, news, msgs) | Genentech (DNA, news, msgs) | | Samsung Electronics | American International Group (AIG, news, msgs) | | Patterson (PDCO, news, msgs) | Danaher (DHR, news, msgs) |
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Source: Fidelity Investments
Danoffs cash holdings have doubled since the first quarter's end. Fidelity declined to make him available for an interview, and the funds Sept. 30 report to shareholders is too bland to explain the move to cash, or indeed much of anything else.
Morningstar analyst Christopher Traulsen attributes Danoffs success to adroit stock picking and aversion to risk. In his recent report on the fund, Traulsen cites successful technology picks, like Yahoo! (YHOO, news, msgs), as well as heavy bets on old-economy names like Avon Products (AVP, news, msgs), which despite a tumble in the last three months is ahead more than 12% in the last year.
A deep bench
American Funds Income Fund of America: This fund, despite its name, is not a bond portfolio but an equity-income fund, which emphasizes dividends as well as interest. As of Oct. 31, it held 49% of assets in domestic stocks, 19% in foreign equities, 24% in bonds and 8% in cash.
| Top Income Fund holdings | | Stock positions as of 10/31/2004 | | | Royal Dutch Petroleum (RD, news, msgs) | SBC Communications (SBC, news, msgs) | | Verizon Communications (VZ, news, msgs) | Bank of America (BAC, news, msgs) | | Dow Chemical (DOW, news, msgs) | Bristol-Myers Squibb (BMY, news, msgs) | | BellSouth (BLS, news, msgs) | HSBC (HBC, news, msgs) | | General Motors (GM, news, msgs) | General Electric (GE, news, msgs) |
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Source: American Funds
You dont need to rely on stock-price appreciation to generate returns, says Drew Taylor, an American Funds spokesman. Income Fund of Americas equity holdings all pay dividends, and a yield on them north of 3% this year has contributed a third of its market-beating returns.
Performance turns on security selection, as it does at Fidelity, but with a twist. The American fund has nine managers (with an average of 18 years experience), each responsible for a portion of the funds assets.
Paul Herbert, a Morningstar analyst, notes that the managers are backed by more than 140 research analysts. Its depth is hard to match, he says.
The other contrast between the six outperformers and the Vanguard 500 Index is that they're actively managed and it's not. And that says something important about indexing.
A volatile mix
There's nothing wrong with indexing per se. The model portfolio of exchange-traded funds that I put together comprises only index funds (and cash, currently at 10%), and as of Nov. 30 was up 9.4% this year. (Had it been a giant mutual fund, the model would've been No. 5 on the above list.)
But the S&P 500 is a volatile mix tilted toward giant domestic corporations. My model has in common with most of these winners a different focus, and much less volatility, which is to say, much greater safety of principal. The models standard deviation is 12.04%, some 24% below the S&P.
In short, Vanguard 500 Index is lagging because it tracks a risky marketplace, and risk currently stinks. Large-capitalization stocks, more than 22% of them in technology, media and communications, which the index represents, are too aggressive for the times. Also, by its nature, an index never buffers risk by holding cash or favoring defensive stocks over aggressive ones.
The market rule of thumb is that high risk brings with it high returns. But that notion is all thumbs in a secular bear market, which were in now, and which tends to run for decades, not years.
In a bear market, dont think offense, like college football. Think defense, like the NFL. Its dull as mud, but sticky money doesnt fly away.
At the time of publication, Timothy Middleton owned the following securities mentioned in this article: Dodge & Cox Stock.
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