4 vehicles for profit, and a way to diversify

Dollars & Sense

April 27, 2003|By William Samuel Rocco | William Samuel Rocco,MORNINGSTAR.COM

The importance of a well-diversified portfolio of funds is painfully clear these days. Although it has shown signs of life in recent weeks, the S&P 500 index has lost 40 percent of its value - or about 16 percent annually - during the past three years. And, many investors began the period overexposed to large-cap U.S. stocks because such issues were at the front of the pack in the late-1990s' surge.

Foreign-stock funds, the first place to which many investors look for diversification, have failed to provide any relief. In fact, the typical foreign-stock offering has lost about half its value - or 19 percent annually - over the past three years, as Europe and especially Japan have encountered more severe economic and corporate difficulties than the United States. These offerings have also disappointed over the longer term. The average foreign-stock fund has lagged behind the S&P 500 index by nearly 5 percentage points per year over the past decade (and underperformed the typical large-growth, large-blend and large-value offerings by 3 percentage points to 4 percentage points per year).

We decided to see if we could find some good diversifiers closer to home. Specifically, we looked for domestic-equity funds that have positive returns over the past three years, low correlations with the S&P 500 index, significantly lower standard deviations than the index and competitive long-term returns. Nearly two dozen funds passed our screens, and we think these four are particularly noteworthy:

Third Avenue Real Estate Value: This fund, like all real estate offerings, provides excellent diversification from the S&P 500 index. It has returned about 14 percent annually since its late 1998 inception, while its average peer has returned 9 percent, and the S&P 500 index has lost 3 percent per year. It also has been far less volatile than both the typical real estate offering and the index. What's more, because manager Mike Winer pays a lot of attention to real estate operating companies (REOCs), which throw off less income than REITs, this pick is much more tax efficient than its peers.

Clipper: Because of its concentrated deep-value strategy and willingness to hold hefty cash or bond positions, this large-value fund rarely moves in sync with the overall market. The fund has crushed the S&P 500 index over the long run and kept overall volatility moderate. But this isn't a tame offering by any means. The management team's penchant for building big stakes in individual names means that issue-specific risk and short-term underperformance are facts of life here. While the fund has posted impressive gains over the past three years, it has lost a painful 8 percent thus far in 2003.

FMC Select: Since its mid-1995 inception, this fund has returned about 14 percent per year - 5 percentage points more than the mid-blend norm and 6 percentage points more than the S&P 500 index. It has kept volatility well under control along the way. Managers Bernard Groveman, William McElroy and Byron Nimocks have accomplished this feat by skillfully executing a value-oriented, all-cap strategy and maintaining a 10 percent to 20 percent bond stake. In addition to buoying returns in recent years - the fund has gained more than 5 percent annually over the past three years - the managers' affinity for smaller caps and bonds keeps its correlation with the S&P 500 fairly low.

Royce Total Return: Chuck Royce and Whitney George's willingness to hold cash and to consider bonds and convertibles bolsters the diversification value of this fund's small-cap focus. That flexibility, as well as Royce and George's emphasis on dividend-paying stocks and valuations, puts a blanket on volatility. And, thanks to their stock-picking prowess, the fund has gained 10 percent annually over the past three years and 12 percent annually since opening at the end of 1993.

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