Is a Convertible Fund Right for You?

With all of the recent turbulence in the market, it's easy to forget that the S&P 500 is up 8.8% for the year. Still, more-conservative investors may have queasy stomachs. One solution is investing in a convertible fund. This relatively obscure corner of the market (there are only 21 funds in Morningstar's database, compared with 670 large-cap blend funds) offers many benefits of investing in stocks, while minimizing downside risk.

The Basics
What are convertibles? These hybrid securities typically start their lives as three-year corporate bonds that can be exchanged for common stock of the issuing company. Investors are generally paid a lower yield than the actual corporate debt, but receive a higher pay-out than the company dividend. If the underlying stock performs well, the bond also increases in value. But if the stock price tanks, investors still receive the principal and interest payments at the maturity of the bond. Of course, there's the risk that a company will default on its loans if times get tough, especially considering convertible bonds are considered more junior to other types of long-term debt.

It's this extra downside protection that makes convertible funds appealing, taking investors on a less volatile ride than straight equity funds when waters are choppy. And while the funds don't necessarily produce chart-topping returns when times are good, they can make up for lost ground by not having to recover as much as their equity peers when markets hit the skids. For example, Fund Analyst Pick Vanguard Convertible Securities VCVSX, the purest play on convertible securities, lost 9% in 2002, while the S&P 500 fell a jarring 22%. Therefore, not only are convertible funds an appropriate alternative to pure equity funds for some conservative investors, but they can also act as an aggressive bond alternative.

The Risks
Of course, converts will be vulnerable at times. While investors garner the benefits of equity and bond exposure, they're also subject to both sets of risks. Given their bondlike characteristics, convertible securities are subject to interest-rate risk, meaning if rates rise, their price falls. Convertible bonds typically earn mid-grade to junk credit quality ratings. That's because many smaller companies issue convertible debt, and due to their lack of market history, they tend to receive lower ratings. This extra credit risk can also increase the volatility of the funds at times.

Furthermore, although convertibles are structured and priced similarly to bonds, their performance is more correlated with the issuing company's underlying stock. When stocks drop in price, convertibles can lose too, although generally not as much as the stock itself. That's because the securities aren't perfectly correlated, and the income stream convertibles pay tends to cushion blows. Still, this behavior can also make for more wobbles in fund performance than the typical fixed-income fund investor might expect.PAGEBREAK

Homing in on Funds
This raises the point that selecting a sound manager is important for convertible fund investors. Convertible securities are tricky to analyze and often not accessible to individuals. Most funds in this category try to strike a balance between upside potential while limiting downside risk, but we think the managers represented on our Analyst Picks list stand out.

As mentioned above, Vanguard Convertible Securities is probably the most pure convertible securities fund, devoting 100% of assets to convertible bonds, while the typical fund has some equity exposure. Manager Larry Keele, of subadvisor Oaktree Capital Management, has successfully guided this fund through the sometimes murky world of convertible securities since 1996. Keele first looks at the structure and price of the security, then the credit quality. The appreciation potential of the stock is the last piece of the analysis. Overall, Keele's experience and conservative strategy and the fund's low fees make it a stellar option.

Those looking for a more aggressive fund will find Calamos Growth and Income CVTRX attractive. Calamos is boutique investment shop that specializes in these securities. John Calamos Sr. and nephew Nick Calamos have more than 40 years of experience investing in convertibles between them--almost unprecedented in this universe. The fund invests nearly half its assets in stocks, making it more volatile than the typical convertible fund, but over the long run, the team has made its risk/reward profile worthwhile.