Conservative Funds Gain Luster in Declining Market

For stock fund investors, one of the lasting effects of this bear market may be a new respect for “middle-ground” portfolio management.

Conservative fund companies, including American Funds, Dodge & Cox and the index-oriented Vanguard Group, typically don’t try to shoot the lights out with their performance in bull markets, but neither do they risk losing massive amounts of their shareholders’ money in down markets.

Fans of these old-school funds say there’s never a bad time to buy them. That may soothe the nerves of investors who want to keep their money in stocks but can’t stand the risk of severe losses if the bear market continues.

“Investors are jittery about where to place their hard-earned dollars, which leads them to funds that have stood the test of time with a sound strategy and low annual expenses,” said William Harding, an analyst at Chicago-based fund tracker Morningstar Inc.

“They know Dodge & Cox, American Funds and Vanguard are not going to do anything crazy. Maybe they didn’t keep up with the Janus Funds and some of the others during the late ‘90s, but their prudent, efficient approach shows that if you have decent performance year after year, slow and steady can ultimately win the race.”

Adds Russel Kinnel, Morningstar’s director of fund analysis: “This market has been highlighting who’s good at fundamental analysis. The funds that bought companies that were faking it a few years ago are getting killed now.”

The strong relative performance of American Funds, Vanguard and Dodge & Cox portfolios this year already has brought many investors to the companies’ doors.

American Funds and Vanguard have been the two best-selling fund groups this year, according to Boston-based consulting firm Financial Research Corp.

At No. 5 in net cash inflows this year, Dodge & Cox’s sales have zoomed as a percentage of its total assets, according to Financial Research. (Vanguard and American funds are the No. 2 and No. 3 fund groups, respectively, based on total stock and bond fund assets, but Dodge & Cox is not in the top 25.)

The Vanguard, American and Dodge & Cox funds have low management expenses, low volatility and a tax-efficient buy-and-hold strategy in common.

American Funds and Dodge & Cox have another major similarity: Their funds are managed by experienced teams rather than by single “star” managers.

At Vanguard, a team headed by Gus Sauter runs the company’s index funds. The actively managed funds are farmed out to sub-advisors.

Vanguard and Dodge & Cox sell their funds directly to investors, without sales charges.

American Funds has a different approach: Its funds are sold only through financial advisors, including financial planners and brokers. That has been the policy of the funds’ Los Angeles-based parent, Capital Group, since its forerunner was founded in 1931.

“A lot of financial advisors are looking over the returns for various funds and saying, ‘Maybe American Funds is not the most exciting company, but the long-term performance is solid,’ ” said Lars Schuster, an analyst at Financial Research. “Some of these advisors might have gotten burned in the past chasing a fund that was up 90% the year before, only to turn cold.”

Harding said several of the American funds, including Washington Mutual Investors, Investment Co. of America, Growth Fund of America and American Balanced, make solid core holdings for any portfolio. The funds are popular in company 401(k) retirement savings plans.

Washington Mutual (which fell 4% in the first half, compared with a 13.1% negative total return for the Standard & Poor’s 500 index) is a “dyed-in-the-wool value offering,” Harding said. The fund cushions its performance by favoring blue-chip companies with a consistent history of paying dividends.

Investment Co. of America (down 7.2% in the first half) is a blue-chip fund whose portfolio mix includes a sprinkling of beaten-down growth stocks along with many classic value names; Growth Fund of America (down 15.6%) is relatively racy, a large-cap portfolio that seeks growth stocks selling for reasonable prices; and American Balanced (down 2.3%) is a stock-bond hybrid “ideal for cautious investors,” Harding said.

All four funds have 10-year returns that rank them in the top 25% of their Morningstar categories.

Harding said American Funds’ weak spot is in the small-cap area: “You may want to look elsewhere for exposure to smaller stocks.”

Dodge & Cox, meanwhile, offers a simple lineup of just four funds (Stock, Income, Balanced and International Stock). The 72-year-old San Francisco-based firm focuses on big-company stocks and is considered more of a pure value shop than American Funds.

The flagship Dodge & Cox Stock fund (down 1.6% in the first half) “only keeps about 80 stocks in the portfolio, but it is never prone to extreme positions,” said Phil Edwards, director of fund research at Standard & Poor’s Corp. in New York. “It’s a fund for people looking for a nice, stable investment, something that lets them sleep at night.”

Dodge & Cox carefully weighs the downside when making investments, said Wendell Birkhofer, one of 10 portfolio managers who run the stock funds with the help of 16 research analysts.

“Our chief investment officer likes to say that we should follow a Hippocratic oath: ‘Thou shalt do no harm to your clients,’ ” Birkhofer said. “We look out three to four years and ask, ‘What is the most pessimistic case if the company doesn’t execute well or the economy goes bad?’ Then the question is, ‘How much of that downside is reflected in the current stock price?’ ”

Though the risk-averse strategy has kept the firm away from landmines such as Enron Corp., Tyco International Ltd., Adelphia Communications Corp. and WorldCom Inc., it was stuck holding Kmart Corp. stock this year when the retailer filed for bankruptcy protection.

“We do make mistakes. We thought the company was making progress in its turnaround strategy, but we were too optimistic,” Birkhofer said.

Still, portfolio diversification paid off, he said: Kmart cost Dodge & Cox Stock about 1 percentage point in performance in the first quarter, he estimated, but the fund still gained 4.9% in the period.

As for Valley Forge, Pa.-based Vanguard, Kinnel said the firm’s index funds are a prime example of how “diversification takes away a lot of the pain of a down market.”

The Vanguard Total Stock Market Index fund, which tracks the Wilshire 5,000 broad market index, lost 11.8% in the first half. That kind of drop has to hurt, but it doesn’t sting as much as the 18.2% plunge for the average large-cap growth fund in the period.

Though the Total Stock Market fund and the Vanguard 500 Index, which tracks the S&P; 500, are diversified against individual stock risk by holding at least several hundred names, they are dominated by their biggest stocks, since the underlying indexes are capitalization-weighted.

That’s why many financial advisors have long championed the idea of portfolio diversification that includes small and mid-size stocks. An equally weighted portfolio of Vanguard’s Small Cap Index, Mid Cap Index and 500 Index funds would have lost 7% in the first half, as the better performance of smaller shares would have cushioned the losses in bigger stocks.

American Funds and Dodge & Cox are known for their prowess with large-cap stocks, but investors seeking conservative, actively managed small- or mid-cap funds might want to consider Chicago-based Ariel Funds, S&P;’s Edwards said.

The flagship Ariel Fund (up 3.8% in the first half), managed by John Rogers, focuses on small-cap stocks. Ariel Appreciation (up 1.2%), managed by Eric McKissack, is a mid-cap fund.

Although the low-turnover funds are sometimes classified by Morningstar as “blend” (a mix of growth and value), the Ariel shop has a value bent, Edwards said.

He also likes New York-based Baron Growth (down 0.8% in the first half), a small-cap growth fund run by Ron Baron, who also uses a buy-and-hold approach.