Think Twice Before Giving These Defensive Funds the Heave-Ho
Although these conservatively positioned equity, balanced, and bond funds have lagged recently, they should serve investors well in more-volatile markets.
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The data are clear: It has paid to be a daredevil over the past five years.
That has been true for stock investors, as small-cap and highly leveraged firms, both in the U.S. and overseas, have led the market's upward march. Investors have bid up the shares of such companies because they are typically among the first and biggest movers in an economic recovery. Small-cap stocks have ceded ground so far this year, but they're still comfortably ahead of large caps since the spring of 2009, when the market began to turn positive. Fidelity Leveraged Company Stock (FLVCX), which specializes in highly leveraged firms that operate in capital-intensive industries, has also soared during that time frame--emblematic of the success of economically sensitive names.
Bond investors have been in "risk-on" mode, too, with lower-quality and longer-duration credits dramatically outpacing shorter-term, gilt-edged bonds over the past five years. The taxable bond group's best-performing categories, preferred stock and high yield, have posted annualized gains of 13% and 11%, respectively, during the five-year period ended Aug. 11. Investors who have hunkered down in cash and high-quality short-term bonds, meanwhile, have barely earned more than 1% over that same time frame.
Yet, recent market volatility has sent a message: Risk-taking may not always be so well rewarded. Amid worries over geopolitical turmoil, not-cheap equity valuations, and the prospect of rising interest rates, riskier assets have taken it on the chin over the past month. (The one notable exception: Emerging-markets stocks, which held their ground better than most foreign stocks, probably because their valuations weren't unreasonable coming into the sell-off.)
The recent volatility is a reminder to rebalance if you haven't done so already and to extend some patience to risk-conscious holdings that have lagged, in relative terms, during this extended equity-market rally. You'll be glad you have them if they hold their ground in a more volatile market.
To help shine a light on some worthy, conservatively positioned holdings that have struggled in relative terms recently, we turned to our Premium Fund Screener tool. We filtered for funds with Morningstar Analyst Ratings of Bronze or higher, then added some performance-based screens, including subpar five-year returns but below-average 2008 losses and good risk ratings.
That screen turned up an attractive mix of defensive-minded equity, balanced, and bond funds. Here's a look at some of the best of that group. You can click here to run the screen yourself or make adjustments based on your own criteria.
American Century Equity Income (TWEIX)
Analyst Rating: Silver | Five-Year Percentile Rank: 94 | 2008 Percentile Rank: 1
This fund's showing over the past five years, while perfectly respectable in absolute terms, lands in its large-value category's cellar. And even its 10-year ranking is merely middling now, obscuring its fine showing during the financial crisis. Morningstar senior analyst Gregg Wolper chalks up that performance pattern to this fund's conservative--and somewhat unusual--positioning. In contrast to most of its peers, this fund's managers typically maintain a 20% to 25% position in convertibles; these securities provide a buffer on the downside but won't tend to gain as much as common stocks during rallies. Management also focuses on large-cap, reasonably valued companies without a lot of debt on their balance sheets--in short, the opposite of what market participants have preferred over the past five years. Yet, Wolper argues that the fund should do a better-than-average job of keeping investors in their seats during periods of market volatility. In fact, the fund's 10-year investor returns, capturing the timing of investors' purchases and sales of the fund, are higher than the fund's total returns. Although the fund was previously closed, it's currently open to new purchases.
FPA New Income (FPNIX)
Analyst Rating: Silver | Five-Year Percentile Rank: 90 | 2008 Percentile Rank: 14
How does a 1-star fund earn a Silver rating from Morningstar's analysts? By focusing on goals that most bond investors share: first, to not lose money, and second, to out-earn the inflation rate over time. An ultra-low duration means the fund has generated anemic returns relative to other offerings in the nontraditional bond category, but that's an imperfect peer group for this idiosyncratic fund. Analyst Sarah Bush notes that the management team has increasingly been gravitating toward less covered, and at times more risky, parts of the bond market, including interest-only mortgage-backed securities and asset-backed credits. But management focuses on only those credits whose yields compensate investors for their risks, and Bush has faith in the long-tenured management team here. The fund remains a solid choice for investors who would like to protect their purchasing power while also shying away from interest-rate-related volatility.
Vanguard LifeStrategy Income (VASIX)
Analyst Rating: Gold | Five-Year Percentile Rank: 82 | 2008 Percentile Rank: 11
Target-retirement funds have hogged much of the attention--and assets--of investors seeking to simplify their investment lives. But so-called target-risk funds, whose asset allocations remain relatively static rather than becoming more conservative over time, can have a role in a portfolio, too. This fund, for example, with its 20% equity/80% bond positioning, could reasonably serve as a holding pen for assets needed within the next five years. It could also stand in as "bucket 2" for investors employing the bucket system for retirement planning.
Its asset allocation is milder than its conservative-allocation peers, which helps explain its lackluster performance during the equity-market rally. That said, its very low costs and well-diversified portfolio of index funds provide lasting advantages. One caution: Because they hold equities, even equity-light allocation funds such as this one are suboptimal for investors who are in active drawdown mode, because they won't exert control over which parts of their portfolios their withdrawals come from. This article explores that point in greater detail.
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