Fund Watch

A Disastrous Year for the Kiplinger 25

We dropped one fund that performed especially bad and replaced it with a less-risky one.

By Andrew Tanzer, Senior Associate Editor, Kiplinger's Personal Finance

October 31, 2008

Let's hope it happens only once in a generation (if not once in a lifetime). Over the past year, virtually nothing has worked for investors. Through October 30, Standard & Poor's 500-stock index plunged a sickening 36% -- and that was less dreadful than the results of international and emerging-markets stocks. Bonds (save for the highest-quality, U.S.-government-guaranteed IOUs), commodities and real estate have all been hammered. There's been no place to hide.

So it's a good time to revisit the Kiplinger 25, the list of our recommended mutual funds. With precious few exceptions, they have felt the full pain of the markets' fury (see how they have performed). Our domestic stock fund picks dropped 40% on average; our international and global fund selections plummeted an average of 46%; and our suggested bond funds surrendered 8.5%. Because our list didn't include any balanced funds or other hybrid products (to make it easier for readers to assemble portfolios without mucking up their asset allocations), none of our favorite stock funds owned enough bonds or cash to insulate them from the horrible market decline.

But one domestic fund performed notably worse than the others: Bill Miller's Legg Mason Opportunity Primary fund (symbol LMOPX). Opportunity shed a mind-boggling 63% over the past year. As a value investor, Miller, who once beat the S&P 500's returns 15 years in a row with his Legg Mason Value fund, committed the cardinal sin of failing to preserve investors' capital for the past two years.

This is not a question of holding temporarily beaten-down stocks that will spring back when the economy and the animal spirits of investors revive. Money that Miller invested in stocks such as Bear Stearns, Freddie Mac and Countrywide Financial is gone for good. So we have decided to drop Opportunity from our list.

We're replacing it on the Kiplinger 25 with FPA Crescent (FPACX). Manager Steve Romick is one of the best, most disciplined value-investing practitioners in the business. He describes his goal as matching the return of the S&P 500 while taking on much less risk. In fact, in the 15 years through September 30, his fund returned an annualized 11%, an average of three percentage points per year better than the S&P index, with about 25% less volatility. Over the past year through October 30, the fund lost 19%.

Morningstar, which categorizes Crescent as a balanced fund, says it beat 99% of its peer group over the past 15 years. Romick makes the most of his flexible mandate by selling short (a bet on lower share prices) when he spots risks that are not reflected in stock prices (think financials for the past year). And he searches among all types of structures for the best values.

For instance, Romick currently finds much better value in corporate bonds and bank loans than in stocks. "Either debt is way too cheap or stocks are too expensive," he says. He recently bought Home Depot debt yielding 12.3% to maturity in December 2009 and bank debt from Michaels Stores yielding 30% to maturity in October 2013. As long as he finds the potential for stock-like returns in more secure fixed-income instruments, he'll continue to snap them up.

If you consider purchasing FPA Crescent, you should be aware that Romick will hold large cash balances if he finds no value in the markets. As a result, this fund will generally lag in bull markets. But because it tends to hold its value better in down markets, it compounds nicely over long periods.

In the bond column of the Kiplinger 25, the outlier is Loomis Sayles Bond fund (LSBRX). It lost 27% over the past year. By contrast, the Merrill Lynch US Broad Market index was essentially flat. Loomis Sayles Bond fund has been an outstanding performer for many years, but it came unstuck as frightened bond investors dumped corporate bonds, whether high-grade or junk.

We expect Loomis Sayles, led by the peerless Dan Fuss, to rebound. But we should emphasize that this is much riskier than a core bond fund. For something less volatile, we suggest Harbor Bond fund (HABDX), managed by Bill Gross and his team at Pimco, or, for money in taxable accounts, Fidelity Intermediate Municipal Income fund (FLTMX).

What's the outlook for the Kiplinger 25 funds? Many of the securities these funds own -- both stocks and bonds, domestic and foreign -- are certainly cheap after they beating they took over the past year. On the other hand, the U.S. economy is almost certainly in recession and economies elsewhere around the world are weakening. That does not bode well for corporate profits, and that could hurt stocks, at least through the first few months of 2009.

In any case, you should have a horizon of at least seven years, preferably longer, for money you invest in stocks. We expect that stock funds, both domestic and international, will generate annualized returns of 7% to 10% over the next seven to ten years.

SEE THE PERFORMANCE OF ALL THE KIPLINGER 25 FUNDS

• Got a question? E-mail me directly at investing@kiplinger.com. Want to be heard? Leave a reader comment below.

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