It ain't rocket science. Stocks with high betas — a measure of volatility — are going to move further on the upside and fall deeper on the downside. Some patient investors (remember them?) know that high-beta issues and funds that focus on them have outdone the S&P 500 during the past decade.
Unfortunately, many shareholders who wound up with high-beta holdings were not sophisticated long-term investors. These include masses of novice investors who poured into technology and aggressive-growth funds at the height of the market. Suffering big losses, the newcomers quickly dumped their shares, dealing themselves out of the reward of holding such shares long-term.
How bad was the damage? A study by Morningstar found that the average technology fund returned 5.3 percent annually during the five years ending May 31, 2002. But few people did that well. Because shareholders bought and sold at the wrong time, the average dollar invested during that period suffered an annualized loss of 9 percent.
Having been so disappointed, many clients are now turning their backs on volatile funds. Once again, their timing might be all wrong. “The time to buy these things is when you're sifting through the ashes and people think they are yesterday's news,” says Michael Stolper, an investment advisor in San Diego.
Among the most reviled former highfliers are sector funds, including specialists in communications, finance and technology. Stolper is particularly keen on technology funds, which should be used as cyclical plays, much like, say, machine tools. Technology earnings are currently still in a trough, because of overcapacity. “Eventually inventories will become tight, and the stocks will bounce,” he says.
While out-of-favor funds can make intriguing contrarian plays, some advisors prefer sector funds as long-term vehicles for adding diversification. Industries such as utilities and healthcare make effective diversifiers because they have relatively low correlations with the S&P 500. Invesco Funds, a leading supplier of sector portfolios, looked at the impact of adding various funds to a portfolio that included only the S&P 500. The researchers found that because the correlations are so low, the addition of a healthcare or utilities fund could provide more diversification than including a small-cap choice or a foreign specialist.
Studies by Ibbotson Associates have confirmed the Invesco results. Ranking a perfect correlation as 1.0, Ibbotson found that the telecommunications sector has a correlation of 0.67 to the S&P index, while healthcare is 0.59. In contrast, the Morgan Stanley Capital International EAFE index, an international benchmark, has a correlation of 0.72.
All this suggests that sector funds can be used in an effort to boost expected returns (while dampening risk) of diversified portfolios. Say an investor holds half his assets in stocks and half in bonds. By adding a sector fund, he may be able to increase his allocation to equities slightly — and therefore raise expected returns — without changing the portfolio's risk profile much. Ibbotson found that adding sector investments to a diversified portfolio could boost expected returns by amounts ranging up to 0.88 percent annually without changing risk outlooks much. “If you pick sectors sensibly, you might achieve better risks and returns over the long term,” says Peng Chen, Ibbotson's director of research.
Chen suggests investors keep their risk tolerance in mind when picking sectors. Those with conservative tastes should consider energy or utilities, sectors with relatively low volatility. More aggressive investors may prefer riskier choices such as technology or finance.
Invesco suggests adding a group of four or five sector funds. This improves diversification while holding risk in check. “By buying a basket of sectors and not trying to time the markets, you avoid the temptation of chasing the hottest funds,” says Tom Kolbe, senior vice president and national sales manager of Invesco.
Advisors seeking a convenient vehicle for using sectors can try Invesco Multi-Sector, a fund that spreads its assets among five sectors: energy, finance, healthcare, leisure and technology. Once a year, the fund rebalances, selling winners and shifting assets to losers so that each category holds an equal share of assets.
Close behind sector funds in the catalog of out of-favor investments are aggressive-growth funds. These scored big gains in the bull market by focusing on fast-growing stocks. While they have spilled plenty of red ink, the aggressive choices are worth a second look. Thanks to huge returns in the 1990s, top performers such as Janus Mercury and Alger Midcap Growth have outperformed the S&P 500 by wide margins during the past five years.
Such funds sport betas in excess of 1.1, indicating that they could significantly outdo the market when the bulls run again. Still, advisors suggest approaching the aggressive funds with caution. “For young clients, it's worth dollar-cost averaging steadily into these funds,” says David Deutsch, a registered investment advisor with Linsco/Private Ledger in Honolulu.
Stolper argues that such growth specialists as RS Investments and Alliance Capital had long records for producing strong returns — until the past three years, a strange period when funds of all stripes suffered disasters. Under more benign conditions, the growth champions will likely thrive again, Stolper says. To benefit from an aggressive growth choice, investors must show Job-like patience. While some advisors suggest holding a fund for three to five years, Stolper says it may be necessary to own an Alliance fund for a decade in order to enjoy the full benefits of the volatile style.
Now could be an intriguing time to buy aggressive funds because most come with big tax losses that could shelter future gains. Consider Janus Mercury. According to Morningstar, the fund has a potential capital gains exposure equal to -110 percent of assets. This indicates that Janus Mercury would likely have to report returns in excess of more than 100 percent before shareholders would owe any capital gains taxes.
That's a nice cushion and a healthy reward for investors who have the discipline to buy volatile funds during a period when they are shunned.
Spread Your Bets
Rough-riding funds that can help you distribute risk
|Fund Deviation||Ticker||Beta||Standard Deviation||R Squared||One-Year Return||Three-Year Return||Five-Year Return|
|Alger MidCap Growth A||AMGAX||1.12||24.77||62||-28.10%||-10.40%||-5.50%|
|Gabelli Global Telecom||GABTX||1.16||20.31||72||-22||-24.5||0.2|
|North Track PSE Tech A||PPTIX||1.72||34.05||67||-34.2||-22.5||7.6|
|Seligman Commun & Info||SLMCX||1.8||35.5||64||-37||-25.8||-1.6|