If you're looking for safety as well as growth from your value funds, there are several criteria you need to keep in mind, writes Russel Kinnel of Morningstar FundInvestor.
We have a few ways of measuring risk. There are volatility measures such as standard deviation, Morningstar Risk, and beta.
Higher volatility means that there is a greater risk of losing money, though these measures are not identical. Some are absolute, and some are relative to a benchmark, while others account for losses more than for advances.
Investors can learn a lot from these volatility measures, but what they often really want to know is how bad things can really get—or how much they might lose in a year, and how much they might lose over an extended period.
To get a handle on that, I chose a core holding category, large value, and pulled return data on the 200 actively managed funds with a minimum ten-year track record. I then pulled the worst 12-month loss for each fund, regardless of when the loss occurred. The past two bear markets were on the particularly brutal side, so it’s quite possible these funds won’t suffer as severe a loss over the next ten years.
One thing that really jumps off the page is that the worst 12-month period for all but four of the 200 came in the 12 months ended February 2009, even though all the funds were around for the prior bear market, too. However, this more recent one was particularly fast and severe, whereas the earlier one was a slower-grinding bear market. In addition, the earlier one hit growth stocks hardest, whereas large value was the center of destruction in 2008.
The 200 large-value funds’ losses ranged from 16.3% for Forester Value (FVALX) to 55.8% for DWS Strategic Value (KDHAX). Among Morningstar 500 funds, American Century Equity Income (TWEIX) lost the least with a 26.5% hit, while Columbia Value & Restructuring (UMBIX) shed 54%.
One-fourth of the funds lost more than 47.7%, one half lost more than 44.6%, and the rest lost less than 41.3%. That best-performing quartile spans a particularly wide stretch from Forester Value’s 16.3% drop to a 41.3% fall. The S&P 500 and funds that track it lost more than 43%, placing them just a hair less than average.
The Best in Class
What are the themes of the funds that lost the least? Cash and bonds are big ones.
The 2008 bear market crushed just about every stock, and, therefore, equity-light funds such as American Century Equity Income, Auxier Focus (AUXFX), Yacktman Focused (YAFFX), and American Funds American Mutual (AMRMX) had a meaningful advantage over their peers. Each one of them typically runs a portfolio with less than 90% in equities.
Auxier Focus is the most conservative, running in the 60% and 70% equity range, while American Century Equity Income runs in the 70% area, with the rest in cash and bonds. Like Yacktman Fund (YACKX), Yacktman Focused will occasionally approach 90% equity levels, but more commonly runs in the 80% range. American Funds American Mutual consistently runs in the 80% range.
Phil Davidson’s other fund, American Century Value (TWVLX), illustrates how dramatic the difference can be. That fund has a similar equity portfolio to Equity Income, but stays fully invested. That fund lost 37% in its worst 12-month stretch, while Equity Income shed 26.5%. American Century Value is still 12th best on the list, but that’s a big gulf.
Davidson also made some smart stock and sector moves, as did the others on this list. In general, the better performers favored more defensive, less indebted companies. And of course, they were light on accursed financials stocks, though most have had larger financials weightings from time to time.
Holding cash and bonds is a formula that should help limit losses in all bear markets. Emphasizing defensive stocks should help in most, even though each one hits a different sector hardest.
But the cash and bond stakes raise a question: Are you better off with stock funds that hold cash and bonds, or should you separate the two and have fully invested stock funds alongside cash and bond funds that give you the same overall exposure?
There are two reasons that an equity fund that can include cash and bonds is the better choice. First is risk tolerance. While the impact on your overall portfolio is similar, some investors get stressed out seeing individual holdings suffer big losses, which can lead them to sell near the bottom.
If that is you, funds with a slug of cash or bonds or even allocation funds, which tend to keep an even larger cash and bond stake, are a good way to go.
The second reason is that you might want to give a good manager some flexibility to adjust his or her stock weighting based on risks and opportunities found. Yacktman has made good use of that flexibility over the years, as have a few others such as Longleaf Partners and Steve Romick at FPA Crescent (FPACX).
Every bear market is different, but cash and high-quality bonds usually serve as bulwarks. Style-box diversification and diversification between bonds, cash, and stocks will help see you through just about anything, even though losses can still happen.
We can see why some funds, particularly those near the top of this list, are less likely to suffer a severe loss than most, but there’s no certainty. Today, the markets have recouped their 2008 losses, but investors who got out late in the bear market and waited too long to get back in have not.
If owning a fund with a mix of stocks, bonds, and cash helps you sleep better than owning funds that hold only one of those asset classes, then embrace that and build a plan that can get you to your goals by using such funds.
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