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Mutual Funds: Going to Extremes

Diversification—to an extreme—is worth a look. How extreme? Some extreme fund managers own everything from common stock to converts to bank debt—all to their investors' delight.

During the bull market, the word “focused” started creeping into the names of many equity mutual funds. By taking bigger bets in fewer stocks (sometimes as few as 20 in a portfolio), you could beat the seemingly unstoppable S&P 500 juggernaut. The theory was: How can you beat the market if — with 150 or more equities in your portfolio — you are, in effect, the market? So, fund managers began to focus on the 20, 30 or 40 names they knew best, the ones they had a strong conviction would produce some serious alpha.

Many of these funds, such as the Janus Twenty, invested in large-cap growth names — and we all know what happened to them. Still, the focused approach is a neat idea, in theory anyway. Used as the “explore” part of a “core and explore” strategy, focus can indeed help produce alpha (outperformance).

At the moment, though, among the most resilient performers in the current, aging downturn have been funds that take a completely different approach — embracing diversification and even taking it to extremes. How extreme? Well, let's just say you'd get a headache trying to put some of these funds in a style box. Some extreme diversifiers own common shares, convertibles and various classes of bonds, from government agencies to junk bonds. “All the finance theory says that you ought to diversify, and the idea actually works,” says Jeff Urbina, portfolio manager of William Blair International Growth, a top performer that is one of the most diversified members of its category.

It can't be underestimated how their idiosyncratic approaches make extreme diversifier funds hard to classify. And that may discourage advisors who prefer funds with pure-style strategies (which are easier to factor into a client's asset allocation plan). But it may be worthwhile to squeeze one unconventional choice into an otherwise regimented portfolio. In downturns, an extreme diversifier can provide some protection, delivering absolute returns at a time when clients have little interest in relative performance.

“Sometimes it pays to consider a manager who knows how to make money and hold down risk,” says Richard Bregman, president of MJB Asset Management, an investment advisor in New York.

To provide stability, Bregman often uses FPA Crescent, a fund categorized by Morningstar as a hybrid. While typical hybrids own a mix of blue-chip stocks and high-quality bonds, FPA has a broader charter. Portfolio manager Steven Romick owns nearly every kind of security, including preferred and common stocks, inflation-indexed bonds, junk bonds, convertibles and bank debt. “People like to pigeonhole managers, and I refuse to be stuck in a box,” Romick says.

Romick aims to deliver stock market returns in bull markets while maintaining low volatility. His style also aims to give up as little as possible in down markets. So far, he has achieved his goals. Since the fund began operating in 1993, FPA has returned 13 percent annually, outpacing the S& P 500 by 2 percentage points. The fund has only recorded one losing year, dropping 6.3 percent in 1999. A diehard value investor, Romick focuses on stocks and bonds of solid companies with blemished records. An example of a big stock holding is Stage Stores, a Texas apparel chain that recently emerged from bankruptcy with a sound balance sheet and increasing sales. FPA has about 15 percent of assets in junk bonds, including many with double-digit yields. Romick says that the rich yields should enable his bonds to outpace stocks in the next several years.

Funds that provide extreme diversification
Fund category 1-year Return 3-year Return 5-year Return Expense Ratio Load Share Classes
FPA Crescent Domestic Hybrid Managers 3.7% 13.5% 7.1% 1.5% No NA
Special Equity Small Growth -22.0 -11.3 1.5 1.29 No NA
Mutual Beacon A Mid-Cap Value -11.4 2.2 4.9 1.14 5.75% A,B,C
William Blair International Growth N -15.2 -12.4 8.0 1.6 No N, 1
Source: Morningstar. Returns through 12/31/02.

Another confirmed bargain hunter is Franklin Templeton's Mutual Beacon, which is classified as a mid-cap value fund. Besides owning unloved domestic stocks, the fund holds about 30 percent of assets in foreign stocks, 20 percent in cash and 15 percent in bonds of companies that are bankrupt or deeply troubled. To limit risk, Mutual Beacon holds more than 100 stocks, rarely keeping more than 2 percent of assets in any one issue. Many holdings have solid niches in markets that may be temporarily troubled. The fund bought B shares of the Washington Post Co. after the publisher's outlook was clouded by a slowdown in advertising. Like many value players, Mutual Beacon lagged the S&P 500 badly in the late 1990s. But the fund has reported only one losing year, and it has consistently ranked as one of the least volatile members of the mid-cap value category.

Even at a time when the markets have favored value stocks, some broadly diversified growth funds have stayed afloat. William Blair International Growth has excelled by holding stocks of all sizes, including a sizable stake in emerging markets.

William Blair only takes companies that look poised to report strong increases in earnings and revenue for the next several years. The fund is willing to pay a premium for strong performance, but it shuns stratospheric prices. After recording big gains with technology stocks in 1999, William Blair began unloading positions that seemed ridiculously expensive. The move helped limit losses.

Investors seeking a steady, small-cap growth-oriented choice, alas, will find few good alternatives among extreme diversifiers; many funds have generated high volatility and big losses. One relatively consistent choice is Managers Special Equity. Managers Funds, which operates the portfolio, attempts to subdue risk by hiring outside managers and splitting assets among two growth and three value specialists. “We pick managers who will deliver good performances at different times,” says Tom Hoffman, director of research for Managers Funds.

Because of the mix of growth and value, some analysts might view the fund's portfolio as a blend. But the high P/Es and volatility of several of the managers tend to drag the ratings of the entire portfolio into Morningstar's growth box. However you classify the fund, its five managers rarely duplicate each other, since they all follow very different strategies. One value specialist is a bottom fisher who only buys stocks that rank in the lowest 10 percent of small stocks according to their price/book ratios. Another value manager looks for stocks with below-average P/E ratios and the potential to show strong earnings gains.

Because of its careful balancing, Managers Special Equity is a steady singles hitter, rarely producing home runs — or striking out. During the past decade, the fund has never landed in the bottom quartile of small growth category for any calendar year, and most often it has finished in the top half. That kind of predictable showing has helped this highly diversified fund outdo its benchmarks and provide some comfort for shareholders in a time of difficult markets.

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