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Recession Ready

How economically sensitive is your portfolio?

Shannon Zimmerman, 03/29/2012

With the economy appearing to pick up speed, and with the third anniversary of the stock market's March 2009 nadir receding, it's worth remembering that the United States has experienced 10 recessions since 1953. The future won't necessarily align with historical averages, of course. Statistically speaking, though, the U.S. could be nearly halfway through its current period of expansion.

Even if that's not the case, recent history underscores why investors need to understand how vulnerable their funds are to an economic slowdown.

Flashback
The financial crisis that came to a head in 2008 and that didn't subside until March 2009 arose from a recession that, according to the National Bureau of Economic Research, got under way in December 2007. The contraction was exacerbated the next year by the freezing up of capital markets: By the close of 2008, bank reserves had climbed to more than 15 times the levels required by the Federal Reserve.

As you would expect, that dramatic tightening had an outsized impact on funds that were heavily exposed to corporate debt at the time. Many fund investors probably know that’s the case from their own experience in 2008. Crunching the numbers is instructive, though, because it underscores just how pervasive the phenomenon was and likely would be again under similar circumstances.

For this article, I calculated the debt/capital ratios--a measure of leverage risk--of the portfolios of all U.S.-stock funds as of June 2008, a date that precedes the Lehman Brothers' collapse and, therefore, the steepest part of the market's 2008 decline. I then divided the universe of domestic-equity funds into quartiles based on their 2008 total returns. The result: Each quartile's average return was inversely correlated with its average debt/capital ratio. The lower that figure, the higher the return.

Two Examples
Royce Special Equity RYSEX illustrates the upside of the pattern. The fund did lose 19.6% in 2008, a decline that was no doubt painful for its shareholders that year. In relative terms, though, Special Equity was an overachiever, placing in the second percentile of the small-value peer group for all of 2008.

One secret of the fund's relative success was hiding in plain sight that year. As is typical of its holdings, the companies in Special Equity's portfolio didn't need cheap and easy access to the capital markets. In June 2008, the lineup's debt/capital ratio clocked in at just 19%--well below the averages for both the typical diversified U.S. stock fund and the small-value category's average entrant as well.

At the other end of the spectrum is Fidelity Leveraged Company Stock FLVCX. A fine vehicle for aggressive investors, this mid-blend fund's debt/capital ratio crested 50% in April 2008 which made its meltdown later that year all but inevitable. All told, the fund shed 54.5% of its value in 2008, faring worse than nearly every other fund in its category.


- source: Morningstar Analysts

Looking Ahead
As of September 2011, the debt/capital figure at Royce Special Equity stood at just 15%, a sign of manager Charlie Dreifus' insistence on conservative accounting and sound financial stewardship among the companies he owns. Leveraged Company Stock’s lineup, on the other hand, clocks in with a debt/capital ratio of 45%, a figure well above that of Vanguard 500 Index VFINX (whose ratio appears in the table above) as well as that of the fund's typical peer.

High in both relative and absolute terms, the fund's recent debt/capital ratio roughly matches its historical norm, and that the fund's exposure to highly indebted firms has been persistently high isn't a surprise given its name. Nor is it difficult to predict that, if the next recession is accompanied by another severe clampdown in the capital markets, this fund will once again feel the effects severely, too.

Yet, predictable though such a showing would be, investors have had a difficult time using the fund well. In the 10-year period through February 2012, it delivered an annualized total return of nearly 15%. Morningstar estimates, however, that the fund's typical investor earned just 2.5% during that time frame.

History isn't destiny, and no single data point is ever determinative. With the cautionary example of Fidelity Leveraged Company Stock in mind, though--and irrespective of when the next recession occurs--investors should aim to understand just how economically sensitive their managers' strategies are and how that has affected their funds' returns in up markets and recessionary ones.

Shannon Zimmerman is an associate director of fund analysis at Morningstar.
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