Mutual Funds That Are the Best of Both Worlds
The Morningstar Investment Conference reminds us of the importance of downside protection.
The Morningstar Investment Conference reminds us of the importance of downside protection.
Temper your expectations: That's the theme that rang out at last week's 2007 Morningstar Investment Conference, where some of the top investing minds made it clear that they think the easy money has already been made in many asset classes.
Such prudence is not surprising considering the number of asset classes that have posted huge gains in recent years. Indeed, more than half of Morningstar's equity and balanced categories--domestic and international--have returned an average of more than 15% annually over the past five years. History tells us such frothiness is not sustainable. At some point, equity returns will likely regress toward their historical range of a bit less than 10% annually--or even much lower. We may not crash and burn, but to paraphrase 2006 Morningstar International-Stock Manager of the Year David Herro of Oakmark International (OAKIX): You shouldn't get used to returns in the midteens, let alone higher.
Other top managers speaking at the conference echoed Herro's circumspection. Mason Hawkins of Longleaf Partners (LLPFX) and Ken Feinberg of Selected American (SLASX) indicated that the market's extended run has forced them to dig deep to find stocks with an adequate margin of safety.
A small cadre of managers thinks that things could get downright ugly. The most outspoken of the every-silver-lining-has-a-cloud group was Bob Rodriguez of FPA. Rodriguez, a prior Morningstar Fund Manager of the Year, is no shrinking violet. He says a dearth of information is masking the risks and future ramifications of the subprime-debt debacle. Long story short: Rodriquez says imperfect credit ratings and out-of-step pricing mechanisms are masking a potential catastrophe that could have a wide-ranging, negative impact on the overall economy.
Have Your Cake and Eat It, Too
The good news is that you don't have to sacrifice performance for downside protection. A proven driver of strong long-term fund returns is simply losing less than the pack when things head south. We screened our database and found loads of funds in a variety of categories that have not only held up well in such down years as 2001 and 2002 but have outperformed over the long haul. We looked for funds with strong bear-market rankings that have also outperformed their category peers over the long haul.
Today we'll browse some favorites from the domestic-equity side. In a subsequent Fund Spy we'll review the best of the overseas crowd.
Value Hounds Excel
Not surprisingly, value managers top the heap. Their parsimonious ways and willingness to hold cash when stocks are dear give them plenty of downside protection and cash to work with if the markets plunges. In fact, a number of top funds always keep big cash hoards--at times exceeding 30% of assets. The strong long-term records at such shops as Weitz, Longleaf, Mutual Shares, and FPA prove that cash in the right hands is not a four-letter word. A few lesser-known funds have also succeeded by keeping a good bit of dry powder on hand. Delafield , Fairholme (FAIRX), and Franklin Balance Sheet Investment (FRBSX) all have solid bear-market credentials and overall records.
A second group of value-leaning investors has kept less of a cash buffer and succeeded largely via strong stock-picking. Bill Nygren of Oakmark Select (OAKLX) and Christopher Davis and Ken Feinberg of Selected American (SLASX) and Clipper (CFIMX) are Warren Buffett disciples who have been especially adept at buying top businesses at fair prices and holding them: a winning combination. John Osterweis and his team at Osterweis (OSTFX) have done well in up markets and down markets using an eclectic style that focuses on out-of-favor stocks. And Chuck Royce's lineup of funds has held up fairly well in choppy markets because of an unflinching price discipline.
Growth Crowd Can Win, Too
Even some growth managers have avoided being snake-bit by falling markets. Superior stock-picking has enabled Jensen (JENRX), Hartford Midcap , Columbia Acorn (ACRNX), and FBR Small Cap (FBRVX) to generally dodge the bear while still enjoying strong returns in up markets. Newer funds from Primecap such as Primecap Odyssey Growth (POGRX), Odyssey Stock (POSKX), and Odyssey Aggressive Growth (POAGX) can be expected to perform similarly. They are run by the same team that generated a strong 20-year risk/reward profile at Vanguard Primecap (VPMCX).
The best time to think about downside performance is before a pullback. Thankfully, there are a large number of funds that provide the best of both worlds: downside protection and great long-term performance.
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