Three Funds That Are More Jekyll Than Hyde

For a handful of funds so far this year, less has been more. They offer a lesson on the importance of considering absolute as well as relative returns.

Three diversified domestic-equity funds have gone from the bottom 20th of their respective categories in 2009 to the top 5% so far in 2010 by actually doing worse in absolute terms.  Pioneer Equity Income (PEQIX),  Sequoia (SEQUX), and  Franklin Rising Dividends (FRDPX) each posted double-digit gains last year--returns in excess of their since-inception averages and the historical average of the overall domestic-stock market. It wasn't enough to earn them any love in their respective categories, though. Equity Income trailed 98% of large-value funds while Sequoia and Rising Dividends lagged more than 95% of large-blend funds.

So far this year, Equity Income's and Sequoia's absolute returns are a little more than half of what they posted in 2009, and Rising Dividend's 5.9% gain is far below its 17% advance last year. Yet, their category rankings are now better than more than 96% of their rivals.

The Jekyll and Hyde rankings can be confusing. You might conclude these funds are inconsistent and even volatile. Indeed, they've each gone from the cellar to the penthouse and back before. They've finished at least five of the last 11 full calendar years in or near the bottom fourth of their peer groups, and five other years in the top fourth of their categories. The truth is, however, that these funds are no better or worse than they were in 2009 and are far steadier than their feast-or-famine relative returns would imply. You have to consider their strategies, histories, and the market environment to get their full stories.

More to the Story
In many fundamental ways, these funds are models of consistency. Their managers have been around for years, plying the same conservative, low-turnover, value-oriented strategies for decades. Equity Income's John Carey likes low-priced, dividend-paying stocks and has run the fund since its inception. Rising Dividends' Don Taylor, who has been the fund's manager since 1996, will buy only stocks that have increased their dividends in eight of the 10 previous years and doubled their payouts over that time. Sequoia's Bob Goldfarb and David Poppe are veteran Buffettologists who aim to buy and hold a handful of solid, simple businesses trading below their fair values and will amass cash if they can't find them.

The different strategies produce portfolios that have been defensive in their own ways. Equity Income leans heavily on consumer goods, industrial materials, and utilities stocks but is more diversified across individual stocks (nearly 80). Rising Dividends is more focused with fewer than 50 stocks and big helpings of health-care and industrial materials shares, but all of them have long histories of supporting and increasing their dividends. Sequoia is the most concentrated with about 30 holdings, including large helpings of consumer services, financial, and industrial stocks, but  Berkshire Hathaway (BRK.A) makes up most of its financial stake and the fund has more than a fourth of its assets in cash. All of the funds lean toward high-quality companies: Their portfolios' average returns on equity and assets are higher than those of their typical peers.

Conservative portfolios like these follow a similar pattern--often lagging in raging bull markets like 1999, 2003, and 2009; and losing less or even posting small gains in bear markets like 2000 to 2002 and late 2007 to early 2009. So, the funds have behaved recently as they always have, posting gains that were easily overshadowed by the broad market's surge in 2009, then eking out modest earnings so far in a volatile 2010. Despite the funds' tendency to disappoint in relative terms at times, they've each been successful on an absolute basis. Each of the funds has outperformed the S&P 500 and its category in the 15 years ended July 26 and has done so with below-average to low Morningstar risk scores (which indicates milder-than-average levels of volatility).

Here Endeth the Lesson
To paraphrase my colleague Mike Breen's analysis of Sequoia, staying the course can create the illusion of constant change. These funds haven't altered their approaches over several market cycles. Investors, however, change their minds all the time about the stocks these funds tend to favor, often vaulting the funds from the top to the bottom of their peer groups for short periods. Looking beyond short-term ranking swings to fundamental attributes and measures of absolute performance can help separate faithful funds from the flighty.