Markets

Ersatz Stock Funds

A stock fund with no stocks? That was the key to success in 2008. But was the manager acting in the best interest of shareholders?

By James K. Glassman, Contributing Editor

From Kiplinger's Personal Finance magazine, June 2009

The stock market's decline has been not only devastating but also eerily consistent.

Check the performance over the 12 months ended March 27 of the 14 general categories of mutual funds that invest in U.S. stocks, and you'll find that the worst fund category lost 37% (large-company value) and the best lost 33% (large-company growth).

There was no place for investors to hide. International-stock funds also fell across the board -- by about eight percentage points more than their U.S. counterparts, on average. Of the eight broad sector-fund categories that Lipper follows, six lost at least 32%, one fell 29% (science and technology) and the best fell 18% (health and biotech).

In fact, the only way to mitigate the stock-market debacle was to stay away from stocks. And that is what some stock funds did.

Stock-less success story

The most dramatic case is Reynolds Blue Chip Growth (symbol RBCGX), which in 2008 fell a mere 5%, besting Standard & Poor's 500-stock index by 32 percentage points. When you look at the fund's portfolio, you see why. Manager Fritz Reynolds started 2008 with 11% of the fund's assets allocated to stocks and the rest to cash. By the end of March of that year, his stock proportion had dropped to 1%, and at year-end to zero.

A stock fund with no stocks? That was the key to success in 2008. There were more-moderate examples of the phenomenon. One was Sequoia (SEQUX), a widely admired fund that reopened to new investors in May 2008 for the first time since 1982. The late Bill Ruane, a former classmate and close friend of Warren Buffett, founded Sequoia in 1970. From its inception until last year's reopening, the fund multiplied its investors' money about 200-fold.

Sequoia investors were rewarded last year, at least on a relative basis. Although the fund lost 27%, it beat the S&P 500 by ten percentage points, and a major factor in this triumph was that nearly one-fifth of its portfolio was in cash. Sequoia wasn't alone.

Using Morningstar's screening tool, I first gathered data on all domestic-stock funds that had beaten the S&P in each of four periods (through March 27): year-to-date, one year, three years and five years. From this accomplished cast, I ranked the top 20 performers over the preceding 12 months. All but five specialized in health-care stocks.

Topping the list as a whole was Reynolds, which had risen 0.2%. It was followed by Gabelli ABC (GABCX), which had fallen only 1%. Again, a big reason for its success is that cash accounted for more than one-third of assets. (Another is that manager Mario Gabelli takes relatively low-risk arbitrage positions, buying takeover targets after a proposed merger is announced and betting that the stock will rise a bit more when the deal is done.)

Similarly, Shepherd Large Cap Growth (DOIGX), in tenth place with a decline of 7%, at last report had 34% of its portfolio in cash and 11% in bonds -- despite a statement on its Web site that the fund "will invest in a diversified portfolio of common stocks."

In 15th place, with a loss of 14%, was FBR Small-Cap Financial (FBRSX). Belying its name, the fund's cash stake, at year-end, represented 57% of manager David Ellison's portfolio.

Responsibility

I will save the fifth strong performer for later, but now I have to ask the question that has been troubling me all along: When a stock fund isn't composed almost entirely of stocks, is its manager acting in the shareholders' best interests?

Certainly, if you are among the happy few who invested in tiny Reynolds Blue Chip last year, you will find this question needlessly academic. But on the other hand, by playing asset allocators rather than stock pickers, were managers such as Reynolds and Gabelli doing their proper duty?

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