Funds for the cautious investor.
It's been quite a while since the last bear market. So this is a fine time to check in on fund downside--specifically, the downside capture ratio.
This measure tells you how much of an index's losses are captured by a fund. Say the S&P 500 loses 10%. A fund that lost 12.5% over the same period would have downside capture of 125%. One that lost 7.5% has downside capture of 75%.
That differs from Morningstar Risk in two key ways. First, the Morningstar Risk rating is relative to a fund's Morningstar Category, whereas downside capture is relative to a broad index such as the S&P 500, MSCI EAFE, or Barclays U.S. Aggregate Bond indexes. The further a fund's portfolio diverges from from those indexes, the less helpful the downside capture measure is.
Second, Morningstar Risk looks at volatility in both directions, though it penalizes losses more, whereas downside capture tells you only about the red ink. The reason Morningstar Risk takes a more holistic view is that volatility on the upside can often later mean volatility on the downside.
For this article, I sought funds with low 10-year downside capture ratios in order to find some lower-risk funds. Five-year measures wouldn't include the 2008 bear market. I also selected funds in categories where those broad benchmarks are good fits: U.S. large-cap equities, foreign large-cap equities, and intermediate bonds. To ensure I was on the right path, I screened out funds that had high Morningstar Risk and funds that were not Morningstar Medalists. I included funds closed to new investors because those who own the funds still need to decide whether to keep them.
Foreign Large Caps
First Eagle Overseas SGOVX (50% downside capture ratio) is a name that comes up just about any time you mention low-risk foreign funds. Through a few manager transitions, the fund has stayed true to its mandate of protecting against losses while still growing principal. The fund's losses in 2008 were half the category's. Management aims to reduce risk by finding good companies trading at sizable discounts to their intrinsic value estimate. They also hold cash and gold-mining stocks when the markets look frothy or inflation looks threatening. (I thought they always hold gold.) I worry about management being taxed by a big asset base at a time when comanager Abhay Deshpande has departed. However, with a 22% cash position and 10% in gold, the fund is still a good bet to lose less in the next down market. This fund is closed to new investors, but First Eagle Global SGENX is open and run in a similarly risk-averse way.
Tweedy, Browne Global Value TBGVX (54% downside capture ratio) also employs a value-conscious approach with an emphasis on healthy balance sheets. The fund avoids big individual stock bets, and its currency hedging also reduces volatility. The style here is modeled on Warren Buffett's idea of paying a fair price for a great company such as Nestle NSRGY.
Artisan International Value ARTKX (70% downside capture ratio) continues to look like a keeper for those who got in before it closed. David Samra and Dan O'Keefe hate high valuations and lousy balance sheets, and it shows.
Virtus Foreign Opportunities JVIAX (70% downside capture ratio) is the first growth fund on our list. Rajiv Jain wants growth, but on the quality side where companies dominate their industry. He runs a fairly focused portfolio, but that hasn't led to outsized risk. Its large weighting in India makes it unusual on this list; that's a big risk in a category where most holdings are in developed markets.
Harding Loevner International Equity HLMNX (87% downside capture ratio) also emphasizes quality growth. A portfolio of companies with strong balance sheets and clear competitive advantages makes it a good holding for a rainy day. The fund has a Morningstar Analyst Rating of Silver and boasts a seasoned management team and a modest asset base.
U.S. Large Caps
First Eagle US Value FEVAX (60% downside capture ratio) has done a pretty good job on defense, but its offense hasn't lived up to that of its siblings. You have to be pretty cautious to see the beauty in this one.
Sequoia SEQUX (64% downside capture ratio) is another keeper for those who got in before the doors shut. Following Warren Buffett's emphasis on moats and modest prices, management has produced brilliant results thanks in part to smaller losses in bear markets.
American Century Equity Income TWEIX (66% downside capture ratio) plays defense in a number of ways, including owning convertibles and preferreds, as well as buying stocks with sizable dividends. Phil Davidson has proved to be a steady hand for more than 20 years.
Vanguard Dividend Growth VDIGX (72% downside capture ratio) is one of my favorites. While the traditional equity-income approach is to go for the largest yields, this fund instead looks for stocks where the dividend is likely to grow. In order for that to happen, a company needs a healthy balance sheet, and the combined effect of a dividend and a good balance sheet helps to moderate risk.
AMG Yacktman Focused YAFFX and AMG Yacktman YACKX (74% and 75% downside capture ratios, respectively) place the emphasis on low valuations. These closed funds will build cash rather than bend management's standards on price. That helped the funds to lose much less in 2008 than the S&P 500 did.
Silver-rated BBH Core Select BBTEX (75% downside capture ratio) has steered clear of trouble by emphasizing strong balance sheets and high quality. That's led this closed fund to lag in the past two years, but it has been a gem over the long haul.
Amana Income's AMANX (77% downside capture ratio) Shariah-compliant strategy means it can't invest in financials. That was a golden strategy in 2008. If the next bear market hits somewhere other than financials, it might not do quite as well, but it does avoid companies with large amounts of debt, too.
Parnassus Core Equity PRBLX (79% downside capture ratio) has a different type of screen that sometimes limits downside. This socially responsible fund screens out polluters and companies with poor social or governance records. Of equal importance, though, is management's emphasis on wide moats--that is, companies with strong competitive advantages. These companies are much more resistant to recessions than others and therefore tend to retain more value in downturns.
American Funds American Mutual AMRMX (79% downside capture ratio) invests in dividend-paying stocks with an emphasis on capital preservation. A slug of cash and bonds also helps to moderate risk.
Risk in the bond market is certainly a concern. Rising rates would punish funds with long-duration portfolios, and a recession or other credit debacle would burn funds with low-quality portfolios. The three downside champs listed here are far from risk-free, but they've at least navigated those risks well in the past.
Dodge & Cox Income DODIX (67% downside capture ratio) owns a mix of corporate debt, mortgages, and some government debt. It's a strategy that steadily adds value without the drama of PIMCO-esque macroeconomic calls. The fund generally has less interest-rate risk than its peers or benchmark. Currently, it has duration that is about 75% of the benchmark. Its credit risk, though, is more in line with peers.
Janus Flexible Bond JAFIX (84% downside capture ratio) is run by Janus' other less-famous bond manager, Gibson Smith. I'd prefer this fund to Bill Gross' because Smith has a stable team and he's more likely to be running the fund in the long term. He owns a fair amount of corporate debt compared with peers, but sector rotation is really the name of the game here. Smith and comanager Darrell Watters move among mortgages, corporates, and Treasuries based on their macro outlook, and they've executed quite well over the years.
Fidelity Intermediate Bond FTHRX (89% downside capture ratio) has a new manager, but its stable team gives us confidence. Robin Foley took over in October 2013, and she has maintained the fund's tight focus on risk. The fund has less interest-rate risk than peers and less exposure to high yield. It won't excite in rallies so much as be a welcome source of stability in rocky markets.