Solid to the Core

In the 1990s, while technology stocks soared, large-cap core investments sometimes seemed dull. Holding shares that are cheaper than growth stocks and more expensive than value, core strategists don't often hit home runs. But these funds which are also called funds rarely strike out. And that steady performance has proved a winning approach in difficult markets. During the past three years, large-cap

In the 1990s, while technology stocks soared, large-cap core investments sometimes seemed dull. Holding shares that are cheaper than growth stocks and more expensive than value, core strategists don't often hit home runs. But these funds — which are also called “blend” funds — rarely strike out. And that steady performance has proved a winning approach in difficult markets. During the past three years, large-cap blend funds tracked by Morningstar returned 0.1 percent annually, outdoing large-cap growth funds by 1 percentage point and besting Standard & Poor's 500 index funds.

Perhaps most importantly, the core funds shined when it counted most, during downturns. In 2000, when the S&P 500 lost 9.1 percent, the average large-cap blend fund outperformed by more than 2 percentage points, and some stayed in the black for the first 10 months of 2001. Large-cap core separately managed accounts have also beaten their benchmarks, according to InvestorForce.com. Many top performers have achieved an elusive goal — beating the index by substantial margins, while recording much lower volatility.

Less taxing

Partisans of the core strategy say that the approach has some important virtues that can make it a compelling choice under any economic conditions. For starters, an investor who relies on a single core fund holding can enjoy relatively skimpy tax bills, compared to someone who employs a mix of growth and value managers.

How so? Consider what happens when value stocks drop and growth soars, as occurred in the late 1990s. A core manager who owns both kinds of stocks may be able to sell sinking value stocks and use those losses to offset gains from growth holdings. Meanwhile, in a portfolio that includes two separate funds — a growth and a value portfolio — there may be no coordinated effort to limit tax bills, and managers may even work at cross-purposes.

“Say the growth manager sells Philip Morris at a gain,” says Brendan Naughton, national sales director of Sage Advisory in Austin, Texas. “If the value manager doesn't book an offsetting loss, the investor will be stuck with capital gains taxes. And if the value manager turns around and buys Philip Morris, the investor will pay taxes and still have the same stock in his portfolio.”

Naughton says that the core approach can also save on fees, particularly for investors using separately managed accounts. Say the portfolio has $1 million to invest in large caps. If the investor puts half in a growth choice and half in a value portfolio run by a different manager, the total fees may be 50 basis points. If the whole amount is placed in a single core selection, the fee may drop to 40 basis points because of the sliding scales that are typically used.

While the lower costs have certain appeal, what brings most investors to core funds is their promise of more stable results. Growth and value stocks move in their own distinct cycles, and sometimes one rises sharply while the other falls. In 2000, for example, large-cap growth funds lost 14.8 percent, while large-cap value rose 6.4 percent. Core portfolios tend to fall somewhere in the middle, providing smoother returns. That makes the style a comforting choice for conservative investors.

“The client may feel safer, even though a core fund won't necessarily outperform a mix of growth and value funds over the long term,” says Paul Polries, director of research for Lockwood Advisors in Malvern, Pa.

Core funds may be particularly appealing to clients who want to have at least some assets in whatever sector has been hottest recently. So, if deep-value investments have soared lately, some clients may be inclined to emphasize that category and not listen to arguments about the need to diversify. But an advisor may be able to achieve some diversification by selling the client on a core manager who has the flexibility to own both growth and value, emphasizing whichever is most appealing.

Getting to the core

B.J. Webster of the Wharton Business Group, also in Malvern, says core funds are simple to understand because they tend to track the S&P 500. In contrast, an advisor who recommends distinct growth and value funds will usually have one selection that is underperforming, making clients nervous. “I like to use core funds for small institutions because the committees can feel comfortable,” says Webster.

For decades, money managers employed what are now called core strategies without using the label. In most cases, the managers simply tried to pick the best stocks, and that typically involved a cross-section of blue chips. In the last decade, institutional consultants and outfits like Morningstar began identifying stocks as either in the growth or value camps, and urging investors to focus on investments that fit in a clear category. Some managers began labeling their styles as core to suggest they fell somewhere in between the two extremes. In 1999, Lipper introduced the core category to cover funds that seemed to fall in the middle.

The core category includes funds that follow a variety of approaches. Some managers follow the old-fashioned approach, buying whatever stocks suit their fancy, whether they are fast-growing technology names or undervalued manufacturers. Others aim to stay firmly in the blend box, holding stocks with moderate prices and growth rates.

In the separate account field, major players include State Street Global Advisors, 1838 Investment Advisors, Kayne Anderson Rudnick Investment Management and Invesco Institutional. Kayne Anderson Rudnick runs a portfolio that stays squarely in the large-cap blend box with about 30 blue chips. The holdings typically have moderate prices and projected earnings growth of about 15 percent. The portfolio includes such familiar names as The Walt Disney Co., General Electric, ExxonMobil and Merck. “To keep volatility low, we focus on companies that have extremely reliable earnings,” says Allan Rudnick, chief investment officer.

Invesco Institutional divides its holdings into three categories: stocks with P/E ratios that are at least 20 percent below the figure for the S&P 500, stocks with dividends that are 20 percent higher than the S&P, and growing companies with earnings increases in each of the past five years. The aim is to hold a diversified mix of growth and value stocks, reducing volatility. Portfolio manager Jeff Krumpelman shifts weightings, but he must keep at least 20 percent of the portfolio's assets in each of his categories. The portfolio is currently emphasizing low P/E stocks, which stand to gain the most in an economic recovery. Holdings include Fannie Mae and Morgan Stanley. “When you hold a variety of different styles, something is always working,” Krumpelman says.

A top core mutual fund is Victory Diversified Stock A, which has returned 15 percent a year for 10 years, outdoing the S&P 500 by more than 2 percentage points annually. Portfolio manager Lawrence Babin owns Caterpillar, a classic value stock, and Intel, the semiconductor giant that has been a staple of many growth portfolios. As the fund's name suggests, Babin aims to diversify, but he overweights sectors that seem poised to benefit from shifts in the economy.

Expecting the economy to revive soon, he has been focusing on sectors that seem likely to enjoy the biggest benefits, including basic industries, capital goods and technology. He is backing away from utilities and consumer staples, which should enjoy less of a boost.

Another strong mutual fund is GE U.S. Equity A, which has returned 11.5 percent annually for five years, beating the S&P by 1.5 percentage points while recording less risk. One-third of the fund is overseen by a value manager, one-third by a growth specialist and the rest by a team of 12 research analysts who pick their 60 favorite stocks.

The resulting portfolio tends to follow the S&P 500 industry weightings, but with important exceptions. Last year, GE had a relatively low weighting in technology, since managers thought the sector was overpriced. And because the fund pays close attention to valuations, the portfolio's P/E ratio is often lower than the S&P's. That approach is designed to provide the steady returns that shareholders have come to expect from core funds.

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