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The importance of a well-diversified portfolio of funds is painfully clear these days. Although it has shown signs of life in recent weeks, the S&P 500 Index has lost 40% of its value -- or about 16% annually -- over the past three years. And to make matters worse, many investors began the period overexposed to large-cap U.S. stocks, because such issues were at the front of the pack in the late-1990s' surge.
But foreign-stock funds, the first place many investors look to for diversification, have failed to provide any relief. In fact, the typical foreign-stock offering has lost about half its value -- or 19% annually -- over the past three years, as Europe and, especially, Japan have encountered more-severe economic and corporate difficulties than the United States. These offerings have also disappointed over the longer term. The average foreign-stock fund has lagged the S&P 500 Index by nearly 5 percentage points per year over the past decade (and underperformed the typical large-growth, large-blend, and large- value offerings by 3 to 4 percentage points per year).
Therefore, we decided to see if we could find some good diversifiers closer to home. Specifically, we looked for domestic-equity funds that have positive returns over the past three years, and low correlations with the S&P 500 Index, significantly lower standard deviations than the index, and competitive long-term returns. Nearly two dozen funds passed our screens, and we think these four are particularly noteworthy:
Third Avenue Real Estate Value (TAREX)
This fund, like all real estate offerings, provides excellent diversification from the S&P 500 Index. It also has been a topnotch performer relative to its peers as well as the index. Indeed, it has returned about 14% annually since its late-1998 inception, while its average peer has returned 9%, and the S&P 500 Index has lost 3% per year over the same period. It also has been far less volatile than both the typical real estate offering and the index. What's more, because manager Mike Winer pays a lot of attention to real estate operating companies (REOCs), which throw off less income than REITs, this Analyst Pick is much more tax efficient than its peers.
Clipper (CFIMX)
Due to its concentrated deep-value strategy and willingness to hold hefty cash or bond positions, this large-value fund rarely moves in sync with the overall market. And thanks to its management team's experience and talent, the fund has crushed the S&P 500 Index over the long run and kept overall volatility moderate. But this isn't a tame offering by any means. The team's penchant for building big stakes in individual names means that issue-specific risk and short- term underperformance are facts of life here. While the fund has posted impressive gains over the past three years, it has lost a painful 8% thus far in 2003.
FMC Select
This fund, managed by First Manhattan Co., hasn't received the attention it deserves. Since its mid-1995 inception, it has returned roughly 14% per year -- 5 percentage points more than the mid-blend norm and 6 percentage points more than the S&P 500 Index. It has kept volatility well under control along the way. Managers Bernard Groveman, William McElroy, and Byron Nimocks have accomplished this feat by skillfully executing a value- oriented all-cap strategy and maintaining a 10% to 20% bond stake. In addition to buoying returns in recent years -- the fund has gained more than 5% annually over the past three years -- the managers' affinity for smaller caps and bonds keeps its correlation with the S&P 500 fairly low.
Royce Total Return (RYTRX)
Several small-cap funds passed, or nearly passed our screens, but this one stands out. Chuck Royce and Whitney George's willingness to hold cash and to consider bonds and convertibles bolsters the diversification value of its small-cap focus. That flexibility, as well as Royce and George's emphasis on dividend-paying stocks and valuations, puts a blanket on volatility. And thanks to their stock- picking prowess, the fund has gained 10% annually over the past three years and 12% annually since opening at the end of 1993.
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