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Funds for volatile times
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June 15, 1999: 12:10 p.m. ET
Bond funds are winners, but experts recommend diversification
By Staff Writer Martine Costello
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NEW YORK (CNNfn) - Financial planner Michael Lipsey has a fleet of mutual funds he recommends for gun-shy investors who hyperventilate at the slightest market gyration.
A lower-risk alternative like the Clipper Fund or the Tweedy Browne Global Fund won't necessarily be a chart-topper, but it will absorb a fall better, he said.
"It will be easier to ride out the storm," said Lipsey, an advisor at Creative Financial Group in Atlanta, whose clients have $300 million invested in funds.
Trying to figure out what to do in a bull market is easy when most everything is going up. But decision-making gets a lot more complicated when Wall Street turns red. Financial planners say it becomes even more important for investors to stay diversified -- and calm -- when returns plunge.
"It (diversification) is not a bunch of hooey," said Reuben Brewer, manager of mutual fund research at Value Line Inc. "Are you going to be able to sleep at night if you lose half your portfolio?"
One hint at what may lie ahead is to look back at mutual fund returns during some of the U.S. market's darkest days -- 1974, 1987, 1990, 1994, and the third quarter of 1998. The data, compiled by fund-tracker Morningstar, shows that different categories of bond funds and funds that mix stocks and bonds were top performers.
In stock categories, winners in one year were losers in another. For example, Japan stock funds were the biggest losers in 1990 with losses of 28.83 percent on average, but topped the list in 1994 with gains of 17.22 percent. Likewise, small growth funds fell short by 6.44 percent in 1994 but edged into the black in 1994 with gains of 0.13 percent.
"In the last several years there hasn't been much of a downside," said Scott Kahan, president of Financial Asset Management Corp. in New York. "There hasn't been much of a downside, so people have been spoiled. They don't have a clue as to how it really works."
Any investor who questions the value of diversification only has to look at the turnaround this spring, Kahan said. Large growth stocks led the way until value stocks and small caps started sparking to life in April.
"People who get hurt the most are buying a handful of stocks," Kahan said. "People who have been throwing money at the S&P 500 have to be disappointed now."
A little history
In 1974, the United States writhed in an oil crisis and a nasty bear market that kept all mutual funds but long-term bond funds in the red, the Morningstar data showed. Out of 18 categories tracked at the time, 11 lost between 20 percent and 38 percent. Among the big losers were mid-cap blend funds, small value and large growth.
Then in 1987, 30 out of 46 fund categories rebounded to show positive returns after the largest one-day point and percentage loss in market history. While 7 out of 10 of the top performers were international fund categories, precious metals gained 36.83 percent and natural resources funds earned 11.57 percent. Large growth funds eked out a 4.20 percent gain, while large blend funds earned 2.68 percent.
In 1990, tensions on Wall Street were high in the days leading up to the Gulf War. Municipal and taxable bond funds were big winners, though health funds topped the list with 15.02 percent gains.
By 1994, another trying year for Wall Street, technology funds were second on the list with gains of 16.58 percent. The health sector pulled through with 2.65 percent.
Which funds perform the best?
Brewer studied returns of 5,000 mutual funds and found three that were able to weather two big market downturns -- the third quarter of 1998 and the five-month period of unrest in 1990 from May through October. The winners were USAA Income Fund, Vanguard Wellesley Income Fund and Vanguard Preferred Stock Fund.
But only the USAA fund, which is in Morningstar's long-term bond fund category, withstood the 1987 market meltdown.
The Vanguard Wellesley fund is a domestic hybrid fund, meaning it invests in bonds and dividend-paying stock, according to Morningstar.
The other Vanguard fund, also a long-term bond fund, is geared more as an investment for companies because of a tax law allowing them to deduct some of the dividends they receive, Brewer said. But it is open to individual investors, he said.
Other top performers in Brewer's study are T. Rowe Price Capital Appreciation Fund; Hotchkis & Wiley Balanced Fund; IAA Asset Allocation Fund; Merger Fund; and Stein Roe Balanced Fund. The funds didn't necessarily have positive gains in all of the downturns but they outperformed their peers, the study found.
"For individual investors, the moral of the story is diversification," Brewer said. "The top three funds are income funds. That says something. These are staid companies, with some bonds."
Roger DeBard, manager of the Hotchkis & Wiley fund, said he invests in value stocks and intermediate-maturity, investment-grade bonds. The stocks have a price to earnings ratio of 15 or lower; pay a good dividend and have promising growth potential, he said.
Three top holdings of DeBard's fund include Marathon Group (MRO), a domestic oil and natural gas producer; Tenneco (TEN), an automotive parts maker; and KeyCorp. (KEY), a commercial bank.
Other research by mutual-fund experts shows that some fund groups weather a downturn better.
Fund groups T. Rowe Price and American Funds were best prepared to deal with risk, according to a review in March by fund-tracker Morningstar.
"With the bull market in its 17th year, this isn't a bad time to start thinking about risk," Morningstar analyst Russ Kinnel wrote in his review of risk levels at fund groups.
What should investors do?
Kahan, of Financial Asset Management Corp., said this is a good time for investors to reexamine their asset allocation. For example, if their portfolio has grown a little light in small caps, they could start buying in that sector.
"With interest rates rising, we're advising people to go back to bonds," Kahan said. He's recommending intermediate bond funds, like PIMCO Total Return Bond Fund.
Peggy Ruhlin, principal at Budros & Ruhlin Inc. in Columbus, Ohio, said her firm requires clients to sign an "investment policy statement." The document means, in effect, that clients promise they will stick to an asset allocation plan no matter what is happening on Wall Street and what the pundits are saying.
"They can't let fear or greed take over and violate the rules of the game, nor can we," Ruhlin said. "If you have rules for the game, you don't have to worry about emotions overcoming what's right or wrong."
Ruhlin said a category such as emerging markets might be number one during one year and a big loser in another, so it's impossible to try and predict what the market will do.
"Individual investors should probably do nothing," Ruhlin said.
Lipsey, of Creative Financial Group, recommends Fidelity Dividend Growth Fund and Fidelity High Income Fund, a well-regarded junk bond fund that pays a good dividend.
Lipsey also advises investors they shouldn't steer clear of the market despite the volatility. After the 1987 crash, he said, he called about 70 clients urging them not to pull their investments out of the market. Only one person listened, and the rest missed out on a remarkable rally.
Then in 1990, Lipsey called his clients again. He told them it was probably their last chance to get into the market while the Dow Jones industrial average was under 2,500. But the markets were jittery and people were anticipating war in the Gulf. Nobody listened.
"As soon as we invaded Kuwait, the market took off,' Lipsey said. "And it never looked back." 
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