The Story Behind a Top Conservative-Allocation Fund's New Rating

 Westwood Income Opportunity (WHGIX) has made good use of its freedom.

This newly rated Bronze offering is one of the best in the conservative-allocation category for the year to date, with a 9.8% return through Oct. 10. Given that its equity stake is now twice the category norm of 25%, its outperformance during a stock rally may seem a given.

There's more to the story. Since its late 2005 inception, the fund has returned an annualized 7.3%, compared with 4.5% for its average peer. Its mild loss in 2008 reflects a lower stock allocation (between 20% and 40%) dating back to 2006, when manager Mark Freeman couldn't pass up 6% yields on high-quality bonds. That quality focus held it back in 2009. Freeman began buying attractively valued equities following the financial crisis and kicked off a great run.

The fund is now on the cusp of Morningstar's moderate-allocation category (which includes funds with equity stakes between 50% and 70%). Yet its risk profile is in line with the conservative-allocation category: Its Morningstar Risk ratings, which emphasize downside risk, are below average over the five-year period. With rising rates an inevitable threat to fixed-income investments, this fund is positioned to hold up better than many of its peers over the near term.

How to use it? Its quirky custom benchmark is not much of a guide: 25% S&P 500 Index, 25% FTSE NAREIT Equity Index, 25% 3-month T-bills, and 25% 10-year Treasuries. Freeman says that isn't a neutral allocation but that it reflects the fund's ability to move among a wide range of securities, with REITs standing in for master limited partnerships, convertible bonds, and preferred stocks. He says it would be fair to consider this an alternative to a 60/40 balanced fund. It has beat  Vanguard Balanced Index (VBINX) by a percentage point annualized since inception with lower standard deviation.

It is not for investors looking to maximize income but is a strong choice for those who share Freeman's goal: attractive total return with moderate risk. 

Process
This fund invests in only income-producing securities, but income is not the goal. Like Westwood's equity funds, it has a dual mandate: to earn an attractive total return, while maintaining a low volatility profile.

Westwood's investment process involves three steps. Industry analysts first look for underpriced companies with strong free cash flow even in stressful environments, improving return on equity, and strengthening balance sheets (meaning companies that are reducing debt or are not overleveraged and can self-finance their growth). They look for situations where the upside potential outweighs the downside risk. Then each investment case is challenged by one of Westwood's sector research groups; those that pass are placed on an approved investment list. Finally, portfolio managers construct a portfolio using internal models to monitor exposure to fundamental risks.

Freeman differs from Westwood's equity fund managers in that he evaluates a prospect on the "approved portfolio candidate list" by looking across the capital structure to decide what is the best way to invest: stocks, high-quality bonds, preferred stocks, or convertibles. He also invests in REITs and MLPs, considering them ways to get equitylike exposure with less risk. Fixed-income and equity allocations are unconstrained, though Freeman says neither would go to 100%.

Portfolio
The fund holds 60-80 securities, which is a relatively low number for a fund in an allocation category. (Bond portfolios tend to hold more securities than stock portfolios.) That's an indicator that security selection, not asset-class maneuvers, drives this strategy.

At more than 20%, cash is at a historical height, and Freeman says it is likely to remain high. This stake is a proxy for overvalued fixed-income holdings; the fund's bond stake is just more than 10%. (Historically, bonds have been higher than 40%.) Freeman says that he could easily find equity opportunities, but the fund's overall risk profile is a consideration. He says the cash is ready to deploy when rising rates create fixed-income opportunities.

The fund's equity stake is currently greater than 50%, including about 15% in REITs and MLPs. Freeman considers these lower-risk equity alternatives, and convertibles and preferred stocks also fall into that camp. (These are included in the 9% "other" stake.)

While the fund's REITs stake is high relative to the category, Freeman says that rich valuations prevent him from adding more. MLPs have helped drive strong returns this year. Freeman has been trimming these names back but does not consider them extremely overvalued. Recent pick  Qualcomm (QCOM) gives exposure to rapidly growing Internet companies at a more attractive valuation.

Performance
This has been one of the top performers in the conservative-allocation category: Since inception through Oct. 10, 2013, it has returned an annualized 7.3%, compared with a 4.5% average. However, the fund's three-year average equity allocation of 49% puts it on the cusp of the moderate-allocation category. That raises the question of whether this equity stake has driven the fund's relative rankings.

This is not simply a story of more stocks leading to stronger returns. The fund's relatively mild loss in 2008 was the result of a lower stock allocation dating back to 2006, when Freeman couldn't pass up 6% yields on high-quality bonds. A quality focus held the fund back in 2009 (Freeman avoids high-yield and emerging-markets debt), but Freeman bought attractively valued equities and kicked off a great run since.

The fund's risk profile is in line with the conservative-allocation category. Its Morningstar Risk ratings (which emphasize downside risk) and standard deviation are average over the three-year period and below-average over the five-year.

Even so, the fund holds its own in more-aggressive company. While it trailed the moderate-allocation category over the past year through Sept. 30 (returning 8.9% versus 11.9%), it kept pace over the trailing three years (with an annualized 9.3% return versus 9.6%). Over five years, it beats that standard (9.8% versus 7.9%).

People
Lead manager Mark Freeman is CIO of Westwood Holdings Group. He is responsible for overseeing the firm's investment and research functions and for developing its economic outlook. Before joining Westwood in 1999, he worked for KPMG and First American Corp. as a senior economist and fixed-income strategist.

Freeman has run this fund since its late 2005 inception and separate accounts with the same strategy since 2003. Comanager Todd Williams has also been on the fund since inception and at Westwood since 2002. He leads Westwood's energy/materials/utilities research group and is a member of the financials/REITs research group.

Freeman and Williams work with Westwood's entire investment team, which includes more than 20 portfolio managers and analysts. The managers and analysts cover sectors across the market-cap spectrum, divided into four groups: consumer/health care, energy/materials/utilities, financials/REITs, and industrials/technology. All contribute stock picks, which must be approved by one of the research groups before making it onto a central buy list. This team has grown steadily, with minimal turnover.

At latest count, Freeman has more than $1 million invested directly in shares of this fund. 

Parent
Westwood Management, advisor to most of the Westwood Funds, is a wholly owned subsidiary of Westwood Holdings Group (WHG). Susan Byrne, founder and chairman, handed over investment responsibilities in 2012, but a well-established strategy and careful planning have ensured consistent management. The funds rely on team-based research involving more than 20 portfolio managers and analysts.

These teams also subadvise a number of funds, including the TETON Westwood funds (formerly Gabelli Westwood). While most of the funds directly advised by Westwood are fairly young, its mutual fund track record extends back to 1987 with TETON Westwood Equity (WESWX).

All Westwood Funds have at least one manager in place since inception. Nearly 90% of assets were in funds with manager tenures of six to nine years--excellent considering only one has a 10-year record and three opened in late 2012.

This growth has not obviously taxed the core management group: A high-yield fund is subadvised by Sky Harbor Capital Management, and three funds that invest abroad are run by an established team hired away from another asset manager in 2012.

Not all the funds have significant manager investment, although Westwood managers do invest in identical strategies through a trust and retirement plans. Fund fees are generally average or above average.

Price
This fund's expense ratio has come down as assets have increased. At 90 basis points, expenses are average for the Institutional class, which represent the bulk of assets invested. The A shares, which have seen significant inflows over the past year, also have average expenses for their class, at 1.15%. 

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