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ADVENTURES IN BONDAGE
by David Snowball

 Based on the record of the past 70 years, stocks have handily outperformed all other asset classes (cash, real estate, bonds, gold, and so on). There are, however, three characteristics of stocks that you need to consider:

They tend to be quite volatile over more-limited periods. A 30% decline in a year is as possible as a 30% rise. As the 1970s showed, periods of weak performance can last for a decade.

While they show substantial price appreciation, they pay out relatively little in income. For the S&P500 companies, the average dividend payout is under 2%.

The various types of stocks (large, small, value, growth) often move in synch, so that a collapse in the short-term prices of large cap stocks will be accompanied by a similar collapse in small cap stock prices.

Because of these characteristics, you should consider supplementing your stock holdings with investments in other asset classes. In this portion of the list, we’ll discuss three sorts of funds: money market, bond and hybrid funds.

Money Market Funds are a bit like savings accounts on steroids: they offer much heftier returns than savings accounts for a very small risk. Money markets invest in a variety of things, including domestic and foreign bank CDs and something called "commercial paper" (basically, very short-term loans to credit-worthy companies).

These accounts are not insured: the price of a higher return is a risk of some loss of your principal. Having said that, I should admit that the risk is very low. Fund companies know that money markets are being sold as "risk-free" investments, so they tend to be pretty cautious about how they invest your money. In several cases, the fund companies have poured money into money market funds to cover losses from the funds’ investments.

The spread in performance between great money market accounts and mediocre ones is very small, typically a fraction of one percent. Most return a bit over 5% per year. Virtually all funds listed as "top performers" at any given time are receiving expense reimbursements from their parent companies and their place on the list lasts only as long as the reimbursement does. As a result, your first criteria for selection might be identifying the fund family or complex through which you make your stock and bond investments. Using their money market will cost little in terms of performance and will ease the movement of funds between accounts.

Money market accounts which are available for $50/month through an automatic investment plan include: Chicago Trust MM, Fremont MM, Heartland-Portico MM, Invesco Cash Reserve, Neuberger & Berman Cash Reserve, Preferred MM, Strong MM, and T. Rowe Price Prime Reserve. Chicago and Invesco impose a $500 minimum on any check written against the account; the other funds have a $250 check minimum.

Two factors strongly influence the risk and returns of bond funds: the average duration of the bonds in the portfolio (which might range from six months to 30 years) and the credit-worthiness of the institutions issuing the bonds (which ranges from AAA to C or unrated). Your returns rise as the duration becomes greater and as the credit worthiness goes lower. Then, too, so does your risk. I’ll make note of only two sorts of bond funds: ultra-short and intermediate term. Why? Because more and more folks are approaching ultra-short funds as an alternative to money markets and because intermediate bonds represent the best risk/return profile (about 90% of the return of a long-term bond with 50% of the risk).

Ultra-short Bond Funds move one step further out on the risk-reward continuum. They’ve been paying between 6-6.5% over the past three years, which represents a 25% greater return than most money markets offer. Two of the best:

Strong Advantage, which Morningstar rates as the top ultrashort fund. It boosts returns (6.7%) with a slug of lower grade securities (half of the portfolio is rated BBB or below). Those securities hurt the fund when a recession occurs (it was the bottom fund in its small group in ’90) and boost it during a recovery (it returned over 10% in ’91). Average duration is 6 months, average credit quality is A. The management team is aware of the risk and has a number of procedures that have mitigated it so far. The fund has, for example, lost money in only 2 months over the past nine years. Sharpe ratio: 2.94. $50/mo with an AIP, $1000 IRA and $2500 otherwise.

For those uninterested in Strong’s credit risk, Smith Breeden Short Duration U.S. Government Securities is a decent alternative. The fund invests at least 70% of its assets in U.S. government securities. This fund lags Strong’s return (6.3%), but boasts a AAA credit rating with the same 6 month average duration. Sharpe ratio: 1.31. $50/mo with an AIP, $500 IRA and $250 otherwise.

Intermediate bond funds tend to mix a core of US government bonds with investment grade corporate bonds and, typically, small amounts of international, emerging market and junk bonds. These bonds are less interest rate sensitive than longer-term maturities: a 1% rate rise will send the price of long bonds down 12% and intermediate bonds down 6%. Of course, the reverse is also true: a 1% rate drop boosts long bonds by 15% and intermediates by 7%. Three funds to consider:

Strong Corporate Bond is one of the top funds over the past five years, finishing in the top 10% in each individual year and the top 1% overall. The fund has returned about 10% per year over the past three and five years. Like Strong Advantage, it carries a bunch of lower-rated securities (75% of the portfolio is BBB or below). The management, nonetheless, seems able to keep risk in balance with returns. Average credit rating is BBB; average maturity is 5.5 years. Sharpe ratio is 1.58. $50/mo with an AIP, $1000 IRA, $2500 otherwise.

Bill Gross is the country’s best bond investor, a veritable Peter Lynch of the fixed-income world. Mr. Gross’ services are normally reserved for PIMCO customers with $5,000,000 or more to invest. He also advises two low-minimum funds: Fremont Bond and Harbor Bond. The funds show many statistical similarities: the same average credit rating (AA), average maturity (4.9 years), Sharpe ratio (1.07), expenses (.70%), Morningstar rating (four stars), category rating (above average), R-squared (about 90) and decile rank within category (top decile). Fremont has a bit higher return (9.7 vs. 9.2) and a bit higher volatility (s.d. 5.2 vs. 4.7), holds much less cash and a bit more lower-quality securities. Harbor is available for $500 with an AIP, $500 IRA or $2500 otherwise. Fremont is available for $50/mo with an AIP, $1000 IRA or $2000 otherwise.

Domestic hybrid funds invest in a combination of stocks and other assets (cash, bonds, convertibles, and real estate). These funds offer much more protection in a market downturn than any pure equity fund, though they inevitably lag in a rising market. I’ll briefly highlight five very good choices.

General Securities is one of those invisible winners in the mutual fund world. It has had the same manager since 1951 (!), it has been in the top quarter of its peer group for the past 1, 3, 5, 10 and 15 year periods but has only $50 million in assets. The portfolio is divided between cash and stocks, with its stock position ranging from 25 to 80% of assets. The manager buys only stocks of companies that practice Total Quality Management and that are undervalued. Currently the portfolio holds 29 issues, ranging from microcaps to giants though the median market cap is $4 billion. Sharpe ratio is 1.83. $100/mo with an AIP, $500 IRA or $1500 otherwise.

Invesco Total Return has about 62% of its assets in large cap value stocks, 30% in high quality, intermediate term bonds and the rest in cash. That balance is set by a model which relates the S&P’s return with long bond yields. The fund has consistently been in or near the category’s top decile, has low risk and below average expenses. Sharpe ratio: 2.19. $50/mo with an AIP, $250 IRA or $1000 otherwise.

T. Rowe Price Capital Appreciation has a more exotic portfolio mix: 54% common or preferred stock, 14% cash and Treasuries, 3% bonds, 30% convertibles (bonds which can become stocks). The equity portion tends to be midcap value stocks. The combination of value stocks and a small bond position gives Cap returns in the top third of its category and risks in the bottom decile. Expenses are below average. Sharpe ratio: 2.28. $50/mo with an AIP, $1000 IRA or $2500 otherwise.

Westwood Balanced has about 60% of its assets in large cap blend stocks, 40% in high quality, intermediate term bonds. Susan Byrne, the equity manager, limits the portfolio to 40 issues, weights each equally and scrupulously rebalances so that she’s continually buying low and selling high. The process forces her to continually reevaluate her underperforming stocks. Westwood’s returns are in the group’s top 4% for the past 3 and 5 years while risks are in the bottom decile. Expenses are average, Sharpe ratio is 2.46. No minimum with an AIP, $1000 otherwise.

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