Seeking Strength in Good Times and Bad

By PAUL J. LIM

Oct. 6, 1998 12 AM PT

TIMES STAFF WRITER

By now, most investors are only too aware that the average stock mutual fund tanked in the third quarter.

What many would like to know is which funds held up best--and perhaps more important, which funds could be expected to fare better than the average fund if Wall Street’s bad times are going to hang around for a while.

The obvious answer, on both counts, is so-called bear market funds, which specifically bet on, or are “hedged” for, a down market, usually by “shorting” the market with stock index futures or with individual stocks.

Those specialized funds include Rydex Ursa, Prudent Bear and ProFunds UltraBear. Just as you’d expect, when the Standard & Poor’s 500 index lost 10% in the third quarter, these funds gained--10.9%, 21.9%, and 16.4%, respectively.

Because these funds are designed to do pretty much the opposite of what the overall stock market does, though, most investors probably wouldn’t want to rely on them as core holdings.

So, we set out to find stock funds that both invest for gains--and thus are suitable as core holdings--and that have historically held up better than their category peers when the market has slumped.

We started with Morningstar’s universe of 6,023 mutual funds that invest in stocks.

First, we eliminated all funds whose total returns didn’t beat at least two-thirds of their peers (as defined by Morningstar’s various mutual fund categories) in the month of August--the period in which stocks pulled back most violently during this year’s market dive.

Notice we said “peers.” Not only is it unfair to judge, say, a small-cap fund’s performance against that of a large-cap fund, it does a disservice to investors.

Moreover, if you were to measure funds’ performance only against that of the S&P; 500 in recent months or years, no fund that invests in small-cap or emerging markets equities would make the list. You’d be left with an undiversified group of large-cap growth funds.

The initial screening left us with 1,987 mutual funds. Of those, we eliminated all funds that did not beat the average fund performance in their categories in the years 1994 and 1990--the last two weak or down market years.

Next, we considered fund manager tenure, to make sure credit for 1994 or 1990 performance would not be going to folks who weren’t in charge then. Thus any fund that had changed managers since 1990 was eliminated.

This winnowed the list to 23 funds.

Then, considering the possibility that the bull market might come back to life in the next several months, we wanted to be reasonably sure we were looking at funds that had also done well when the market did.

So we tossed out those funds that didn’t finish in the top two-thirds of their respective categories, in terms of total returns, during the last 12 months, three years and five years.

Once we eliminated funds closed to new investors, we were left with a list of seven funds: three large-cap funds, one mid-cap, one small-cap, one world (global) stock fund and one sector fund.

Note: All of these funds did lose money in the third quarter. The thing to keep in mind is that they lost less than their peers.

Here’s a look at the seven:

* Vanguard U.S. Growth (no load; minimum initial investment: $3,000; [800] 662-7447). Some of the best-known stocks in this $11-billion large-cap growth fund got shelled during the third quarter--names such as Coca-Cola, Procter & Gamble and Disney. Yet during that period, U.S. Growth fell 16% less than its large-cap growth fund peers.

U.S. Growth did well in the other recent down markets: It delivered a total return of nearly 4% in 1994, when its peers fell, on average 2%; U.S. Growth advanced 4.6% in 1990, when the average large-cap growth fund fell 2.1%.

One reason is that this is a fund that settles for singles and doubles when other growth funds swing for the fences.

For instance, the fund will invest in companies whose earnings are growing 13% to 15% a year. “That’s not mind-bogglingly fast, but we do think there’s a greater probability that these growth rates can be achieved,” said co-manager David Fowler.

Indeed, well more than 90% of the 70 stocks in the fund’s portfolio sport an “A” grade or better based on Standard & Poor’s equity ranking system, which considers the stability of a company’s earnings and dividend growth during the last decade.

The fund also pays attention to valuations. In recent months, for instance, the fund trimmed its holdings in Dell Computer as the stock price--and therefore price-to-earnings ratio--soared.

Thanks to the cautious approach, U.S. Growth has beaten at least 80% of its peers during the last one, three, five, 10 and 15 years.

* Dreyfus Appreciation (no load; minimum initial investment: $2,500; [800] 373-9387). When stocks are treading water or being pulled under, and every fund manager is struggling, those whose funds have low expenses have an automatic performance edge.

This $2.7-billion large-cap growth fund boasts an annual expense ratio of just 0.87%, compared with the category average of 1.43%.

Also, whereas the typical stock fund’s turnover rate is 90% (which means it replaces nearly all the stocks in its portfolio each year), co-managers Fayez Sarofim and Russell Hawkins keep this fund’s turnover rate down to a staggeringly low 1%.

“We think investors make the mistake of thinking of volatility as a time to make money,” Hawkins said. “We think it’s an opportunity to get whipsawed and overtrade, building up expenses from a tax and trading-cost standpoint.”

Of course, a fund that sticks with its picks this way must pick stocks well to turn in the kind of performance Dreyfus Appreciation does. And Sarofim and Hawkins are masters.

Thanks to long-term holdings in companies such as Pfizer, Johnson & Johnson, and General Electric, the fund has appreciated 21.5% a year, on average, for the last five years.

* GAM North America A (5% load; minimum initial investment: $5,000; [800] 426-4685). Aside from its higher fees, there’s very little difference between this $12-million large-cap growth fund and Dreyfus Appreciation.

Fayez Sarofim also manages this slightly younger fund, and its top holdings, according to recent reports, are virtually the same. This fund’s turnover rate, at 9%, is also extraordinarily low.

In terms of performance, GAM North America, like Dreyfus Appreciation, has beaten at least two-thirds of its peers during the last one, three and five years.

* Mairs & Power Growth (no load; minimum initial investment: $2,500; [800] 304-7404). Funds that have done well when the market hasn’t often have one thing in common: large cash positions, which provide a nice cushion for fund managers in uncertain times.

Yet this mid-cap fund has remained fully invested in equities in each of the recent flat or down market years--1998, 1994, 1990 and 1987. So how has this $461-million fund held up so well?

Diversification. Manager George Mairs, who has guided the fund since 1980, maintains a mix of large-cap, mid-cap and even small-cap stocks at all times. Currently, half the fund was invested in large companies, about 30% in mid-caps and the remainder in small-company shares.

“The large-cap names obviously helped us this time around,” Mairs said of the third quarter. In 1994, he said, the fund’s small-cap names provided a needed boost.

Mairs’ stock-picking discipline also helps. Although he seeks companies with rapidly growing earnings, he only wants them if they have strong balance sheets. Among his long-term holdings, for instance, is Emerson Electric, a St. Louis company that has increased its earnings and dividends every year for the last four decades.

Such stocks have powered this fund to annualized returns of 20% during the last five years--64% better than the average for its peers.

* Fasciano (no load; minimum initial investment: $1,000; [800] 848-6050). For this $97-million small-cap blend fund, manager Michael Fasciano seeks out companies whose sales, earnings and earnings per share are likely to double during the next three to five years.

But he also looks backward: To reduce risk in his portfolio, he eliminates those companies that can’t demonstrate the following: steady growth; consistency of earnings; strong cash flow; low debt; high degree of insider ownership; and reasonable stock valuation.

Unable to find good growth stocks trading cheaply earlier in the year, Fasciano built up his cash position from 3% of assets in December to 20% as of June 30.

Smart move. He did the same thing for the same reasons before market declines in 1994 and 1990.

The result: While its peers fell 22.5%, on average, in the third quarter, Fasciano fell 13.4%. During the last three years, this fund rose an average of 16.6% a year, about twice as much as the average small-cap blend fund.

Now that Fasciano has cash, look for it to go after bargains in the depressed small-cap sector. Fasciano recently added Tootsie Roll Industries to his fund, now that its price came down more than 25% since the market peaked in July.

* New Perspective (5.75% load; minimum initial investment: $250; [800] 421-4120). This $19.9-billion world (global) stock fund, managed by Capital Research & Management in Los Angeles, takes the team approach to stock picking, believing that many heads are better than just one or two.

The assets of New Perspective are divided into six pieces. Five co-managers each get a slice, and a sixth slice is team-managed. That gives the fund a level of diversification, in terms of stock-picking ideas, most funds don’t have.

The third quarter was brutal for global stock funds overall. Yet, whereas the typical world fund fell 16% in the quarter and is down 3.6% year-to-date, New Perspective fell 10.2% in the quarter and is up 6.5% year-to-date.

Because the managers favor strong blue-chip names and avoid high-risk markets, New Perspective has largely avoided Latin America and other emerging-markets land mines of late. And the fund reduced its Asian exposure earlier in the year.

* Vanguard Specialized Health Care (no load; minimum initial investment: $3,000; [800] 662-7447). The health-care sector is one that many Wall Street pros view as generally non-cyclical--meaning its growth doesn’t depend on how well the economy is doing.

And within a strong market sector, this $7-billion health-care fund has played it very well. Vanguard Specialized Health invests about half its assets in major world drug stocks, which have been red-hot in recent years.

Also, the vast majority of its assets are in U.S. stocks such as Pfizer and Bristol-Myers Squibb, which are industry leaders.

The fund, unlike some of its peers, has largely avoided risky bets on unproven biotech companies or beaten-down health-care management firms.

This formula guided the fund to gains of 16.8% in 1990, when the benchmark S&P; 500 index of blue-chip stocks fell 3.1%, and to gains of 9.5% in 1994, when the S&P; advanced just 1.3%.

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Fund Sectors in Down Markets

How can you predict which fund categories will hold up best in a bear market? One way is to consider performance during the market’s worst months. Here is the performance of major Morningstar equity fund categories, relative to the Standard & Poor’s 500 index, in the 12 one-month periods since Jan. 1, 1990, in which the S&P; 500 lost more than 3%.

For example, the international hybrid category performed 48.2% better than the S&P; in those months, overall, while the Pacific/Asia (excluding Japan) category performed 44.9% worse.

Remember, this is a ranking relative to the S&P; overall, most funds lost value in those months.

This comparison also is used to compile the “Weak Rank” in the special tables from fund tracker Morningstar Inc., on pages C12-C15, where you’ll also find definitions of these categories. (See “Weak Market Rank” explanation on C13.)

International hybrid: +48.2%

Utilities: +36.1

Domestic hybrid: +29.5

Convertibles: +22.8

Real estate: +16.5

Precious metals: +13.4

Europe stock: +11.0

Natural resources: +8.9

Mid-cap value: +7.1

Large value: +4.7

Small value: +3.6

Large blend: +2.7