No matter how buoyant the stock market has been through much of this year, many investors have continued to worry about what could go wrong. Their fears include the possibility of an ill-timed increase in interest rates by the Federal Reserve…wrongheaded policies by a new US president…turmoil in Europe as the UK prepares to leave the European Union…and the fear that stock prices have simply outpaced corporate profits.
If you share any of these concerns or have another reason to question this year’s high stock prices, you may want to “play defense” with at least a portion of your portfolio. Mutual fund expert Todd Rosenbluth says the best way to do that without abandoning stocks altogether is to use funds whose managers are masters of defense. That means the funds are likely to hold up better than the overall market in downturns but continue to provide healthy gains if the market does well. Here’s how Rosenbluth identifies such funds and how you can use them in your portfolio…
3 Key Characteristics
Playing defense has become tricky at this point in the seven-year-old bull market. Traditional strategies that investors have relied on in the past to protect themselves during downturns may not be effective.
Example: Stocks of companies with long histories of reliable earnings and paying dividends typically are attractive as defensive plays. But many of these stocks have become quite overvalued, bid up by income-seeking investors.
Another traditionally popular defensive action—shifting to bonds—is not especially attractive now at a time when interest rates are very low and are expected to rise in the coming years, which would cut into the value of existing bonds.
Instead of relying on those strategies, consider opting for defensive stock funds with the following three characteristics…
Experienced managers with consistent strategies to control risk in the current market environment.
Sustained records of lower volatility. A fund should have exhibited less volatility than its benchmark index and most of its peers over the past 10 years, a span that includes the 2007–2009 bear market.
Histories of good returns. You don’t want to sacrifice too much in gains in exchange for safety.
My Favorite Defensive Funds Now
The funds below are actively managed, no-load (no sales commission) funds that meet the criteria described above and currently are open to new investors.
US large-cap stock funds…
- American Century Equity Income (TWEIX). Although three-quarters of the portfolio was recently in dividend-paying stocks, fund manager Phillip Davidson tries to make sure that they are beaten-down bargains. One-quarter was in convertibles and preferred stocks. Despite the fund’s name, income really isn’t the focus here…stability is. The companies must have healthy balance sheets and exceptionally strong cash flow. Over the past decade, the fund’s returns have matched those of the Standard & Poor’s 500 stock index with about one-third less volatility. Recent yield: 2.1%. Performance: 7%.*
- T. Rowe Price Dividend Growth (PRDGX). Rather than focusing on yields or deep bargains, manager Thomas Huber invests in what he considers to be reasonably valued, cash-rich companies that are growing fast enough to boost their dividends over time and/or reinvest in the business through acquisitions. These criteria often lead him to health-care and industrial stocks, which have held up well in turbulent times in the past. The approach has enabled the fund to consistently outperform the S&P 500 with about 10% less volatility. Recent yield: 1.2%. Performance: 7.8%.
US mid-cap stock fund…
- Parnassus Mid Cap (PARMX). Funds that hold small- and/or mid-cap stocks tend to be far more volatile than the overall market. But Parnassus Mid Cap has been about 15% less volatile than the S&P Midcap 400 index over the past decade while ranking in the top 2% of its category in performance. What really sets it apart is the strategy of so-called socially conscious investing practiced by all Parnassus managers. Avoiding companies involved in alcohol, tobacco, gambling and weapons—whether or not you find it to be an ethically attractive approach—does reduce the fund’s volatility compared with most funds that invest in such industries. And selecting companies that practice good corporate governance helps boost the fund’s long-term returns. The idea is that businesses with positive workplace environments have proved to be less risky for investors and produce higher profitability and earnings growth. Recent yield: 0.6%. Performance: 8.9%.
Foreign stock fund…
- Tweedy, Browne Global Value (TBGVX). This fund invests in about 100 foreign blue-chip stocks that are bought for at least 30% below what the fund’s managers think they are worth. The managers go to great lengths to reduce volatility with additional steps that include avoiding emerging markets…putting up to 10% of the portfolio in conservative US stocks…keeping as much as 20% in cash if there are no attractive opportunities…and hedging foreign-currency exposure to reduce the effects of swings in the value of the US dollar against other currencies. The fund ranks in the top 1% of its category over the past decade with 30% less volatility than its benchmark foreign stock index. Recent yield: 0.8%. Performance: 4.7%.
Allocation funds, which mix stocks, bonds and other investments…
- FPA Crescent (FPACX). Fund manager Steven Romick keeps 60% of the fund’s assets in what he considers to be undervalued stocks. But the remainder can be invested in almost any security on global markets including cash, mortgage-backed securities and foreign bonds. He even can short (bet against) pricey stocks. While this may not sound like an investing formula that allows investors to sleep soundly, Romick, who has managed the fund since 1993, practices it with such prudence and skill that his fund has nearly matched the returns of the S&P 500 over the past decade with 36% less volatility. Recently, Romick had just 6% of the fund in bonds and nearly one-third in cash that he could use when he spots new market opportunities. Recent yield: 0.6%. Performance: 7%.
- James Balanced: Golden Rainbow (GLRBX). This is the most conservative fund listed here. It has offered compelling returns for the risk it takes. Over the past decade, the fund has had 50% less volatility than the S&P 500 while managing to trail the index by an average of just one percentage point annually. During the 2007–2009 bear market, the fund fell 14% versus a 57% drop for the index. Manager Frank James splits his portfolio equally between stocks and bonds. The bonds, mostly US Treasuries, are held to maturity, so he faces little chance of losses on them even if interest rates rise. That allows him to boost returns by taking a bit more risk with the stock portion of the portfolio. James keeps about half the stock allocation in undervalued small- and mid-cap stocks. Recent yield: 0.9%. Performance: 6.1%.
*Performance figures are 10-year annualized returns through September 20, 2016.
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As an investment expert with a deep understanding of the financial markets and mutual funds, I'll delve into the key concepts and strategies mentioned in the article to help investors navigate the challenges associated with the current state of the stock market.
Market Concerns: The article addresses concerns that investors may have in the current stock market environment, including the fear of an ill-timed increase in interest rates by the Federal Reserve, potential wrongheaded policies by a new US president, turmoil in Europe due to the UK leaving the European Union, and the perception that stock prices have outpaced corporate profits.
Playing Defense: To address these concerns without completely abandoning stocks, the article suggests adopting a defensive strategy with a portion of the portfolio. Defensive strategies aim to protect investments during market downturns while still providing healthy gains in favorable market conditions.
Challenges with Traditional Defensive Strategies: The article highlights challenges with traditional defensive strategies such as investing in stocks of companies with long histories of reliable earnings and paying dividends, as well as shifting to bonds. Overvaluation of dividend-paying stocks and the unattractiveness of bonds in a low-interest-rate environment are mentioned as potential drawbacks.
Defensive Stock Funds: The recommended approach is to consider defensive stock funds with three key characteristics:
- Experienced Managers with Consistent Strategies: Managers with a proven track record of controlling risk in the current market environment.
- Sustained Records of Lower Volatility: Funds that have exhibited less volatility than their benchmark index and peers over the past 10 years, including during the 2007–2009 bear market.
- Histories of Good Returns: Funds that have delivered good returns without sacrificing too much in gains in exchange for safety.
Recommended Defensive Funds: The article provides a list of actively managed, no-load funds that meet the outlined criteria:
- American Century Equity Income (TWEIX): Emphasizes stability, with a focus on beaten-down bargains and healthy balance sheets.
- T. Rowe Price Dividend Growth (PRDGX): Invests in reasonably valued, cash-rich companies with a track record of boosting dividends.
- Parnassus Mid Cap (PARMX): Utilizes socially conscious investing, avoiding certain industries for reduced volatility and selecting companies with good corporate governance.
- Tweedy, Browne Global Value (TBGVX): Invests in undervalued foreign blue-chip stocks while employing strategies to reduce volatility.
- FPA Crescent (FPACX): Mixes stocks, bonds, and other investments, with a focus on undervalued stocks and flexibility in asset allocation.
- James Balanced: Golden Rainbow (GLRBX): A conservative fund with a balanced portfolio of stocks and bonds, emphasizing low volatility.
Performance Metrics: Performance figures, including 10-year annualized returns through September 20, 2016, are provided for each recommended fund. These metrics help investors assess historical fund performance.
By incorporating these key concepts and recommendations, investors can make informed decisions when navigating the complexities of the current market environment and tailor their portfolios to address potential risks while seeking reasonable returns.