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Funds

A Downside Litmus Test for Funds

How did funds hold up in a nasty quarter?

You may recall that 2018 ended with a pratfall. In the fourth quarter, the S&P 500 lost 13.5%, and foreign indexes lost around 11.5%. It's been 10 years since we had a true bear market, so these little downturns are useful as tests to see if our expectations about a fund's risks are still on the money.

With that in mind, let's look at a few of the best and worst performers in the fourth quarter and what that tells us about them. And, of course, we are doing this exercise to get a glimpse into a fund's risk profile, not because we think you should select your investments based on returns in a three-month period.

Merger Fund MERFX

Fourth-quarter 2018 return: 1.90%

There are more-sophisticated strategies in the land of alternatives, but plain old merger arbitrage still has lots of appeal. Consider this fund's welcome positive gain amid the wreckage. The basic idea of merger arbitrage is you buy the merger target and short the buyer. If the deal goes through, you should make money. If it doesn't, you will lose money. But because all your risk is issue-specific, you can sometimes make money in a down market. Of course, you generally don't make a lot in an up market, either.

Dreyfus Global Real Return DRRAX

Fourth-quarter 2018 return: negative 1.50%

The typical multialternative fund lost 4.4%, so this fund's small loss looks pretty good. Relative to peers, the fund is a cautious one that you'd hope would make up ground in a sell-off, so this is a good sign. The fund is run by U.K.-based Newton's real-return team. It has a strong long-term track record at the overseas version of the fund. The goal is to hit the Libor return plus 400 basis points. The team uses a variety of equity and bond exposures plus options to dial down risk. The fund does indeed manage risk quite nicely, but I encourage you to look at its annual returns before buying because they are quite modest.

AMG Yacktman YACKX and AMG Yacktman Focused YAFFX

Fourth-quarter 2018 return: negative 3.80%

Now that's impressive for two equity funds to lose only one third as much as the market did, but these funds have long played defense very well. They look for solid companies trading cheaply, and they hold cash when they can't find enough to buy. They've kept cash around 20% lately, so that certainly helped. But they also benefited from quality defensive names like Procter & Gamble PG, Twenty-First Century Fox FOX, and PepsiCo PEP.

American Century Equity Income TWEIX

Fourth-quarter 2018 return: negative 7.45%

Phil Davidson's cautious fund is dependable in bad weather. When combined, high-dividend-paying stocks, convertible bonds, and preferreds are quite likely to lose less in a sell-off. However, Davidson and team pay particular attention to finding sturdy dividend payers rather than simply getting the biggest yield. They look for solid companies with relatively low debt levels, because in a recession, poor-quality dividend payers can sometimes get crushed.

First Eagle Overseas SGOVX

Fourth-quarter 2018 return: negative 7.56%

This is another dependably cautious fund. The emphasis here is on absolute returns. That means playing a lot of defense by adding bonds, gold bullion, and cash to a portfolio of value stocks. Matthew McLennan and Kimball Brooker Jr. play defense by looking for cheap stocks with a margin of safety priced in. They also look for healthy balance sheets. It's encouraging to see this fund still hasn't lost its character nearly a decade after Jean-Marie Eveillard retired.

Now lets review some funds that lost more than the market.

Ariel Fund ARGFX

Fourth-quarter 2018 return: negative 19.00%

This fund might once have been put in the cautious group. After all, the firm's motto is slow and steady wins the race. But quality companies have become too pricey for John Rogers' tastes, and the fund is now more value than quality. In addition, the fund held double-digit cash stakes until 2006. Thus, it is very much part of this fund's evolved look that it would exaggerate market swings rather than mute them.

Primecap Odyssey Aggressive Growth POAGX

Fourth-quarter 2018 return: negative 20.69%

Those huge gains in rallies don't come without risk. I'm not at all surprised to see this closed gem giving up a good chunk of recent gains in a short period. The fund invests in early biotechnology and technology names, after all. Nevertheless, consider that $10,000 invested on March 11, 2009, returned $76,697 over the ensuing 10 years.

Baron Small Cap BSCFX

Fourth-quarter 2018 return: negative 22.07%

Any growth fund is going to have risk, but it is still a little surprising that Baron Small Cap would take a hit this large. Although the fund has a quality emphasis, its 34% tech weighting stung in the fourth quarter. The fund does have much more in companies with wide and narrow Morningstar Economic Moat Ratings than its peers, but its somewhat high valuations and sector concentration signal there is plenty of risk anyway.

Hotchkis & Wiley Mid-Cap Value HWMAX

Fourth-quarter 2018 return: negative 25.82%

You can set your watch to this fund's style. Day in and day out, it will be an aggressive, dedicated value fund. That makes it pretty easy to build a portfolio with. However, you still have to stomach nasty losses when the markets or economy hit a rough patch. The fund has big weightings in energy and financials because they look cheap to manager Stan Majcher. The fund lost 43% in 2008, so no excuses if you didn't know it had risk. But it often comes roaring back, and that's what it did in 2009 and has done so far in 2019.

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