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Cut Risk With Convertible Securities

These obscure investments are ideal for this market because they offer a great way to earn stock-like returns with much less risk.

Looking for a way to reduce your risk in today's market while still earning the returns stocks can provide? A good convertible securities fund could be just what you need.

Convertible bonds earned an annualized 11% from 1973 through 2004, the last year for which returns are available. That's just one-fifth of a percentage point per year less than Standard & Poor's 500-stock index, according to Ibbotson Associates. I don't expect convertibles to do quite that well relative to stocks in the future, but I still expect their returns to be solid.

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Convertibles, meanwhile, are much less risky than stocks. Over those same years, convertibles were about 25% less volatile than the S&P 500. By that, I mean that the monthly returns for convertibles bounced around that much less than stocks did.

Volatility has proven to be a terrific indicator of how stocks, bonds and other securities will hold up during bear markets. Indeed, converts proved their mettle during the 2000-02 bear market, when the S&P 500 plunged more than 47%. During that wretched bear market, the Merrill Lynch All U.S. Convertibles index lost less than 25%.

I'm beginning to think that almost all investors could benefit from devoting 5% to 10% of their portfolios to convertible securities. (The group also includes convertible preferred stocks, which are much like convertible bonds; the major differences is that convertible preferreds typically don't have maturity dates and are lower on the credit ladder should the issuing company go bust.)

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One negative: The issuers of most converts have "junk" ratings. The average convert has a BB rating from Standard & Poor's, which means there's a real danger that its issuer could default. If the junk bond market goes through a rough patch, so will convertibles. That's just one reason you need a smart manager picking your converts.

Converts are obscure and complex securities. Because of that, most investors don't bother with them. Converts are part bond and part stock. Like a bond, a convert pays a fixed amount of interest every year to investors. But convertibles can be exchanged for stock of the issuing company at a preset price.

The bond yield acts as a cushion, keeping the price of the convert from dropping too far. But when a convert is trading close to its conversion price -- in other words, the price at which it would make sense to cash it in for the stock -- it rises and falls in tandem with the price of the underlying stock.

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Most converts trade mainly based on the price of the stock. But when the conversion price is far above the current stock price, converts trade entirely as bonds. These are known as "busted converts."

Don't spend too much time on the bond math. Convertibles are tricky and best bought through a mutual fund.

Two of the best funds are run by Fidelity and Vanguard. Both funds hold a smattering of convertible preferreds, but mainly they invest in convertible bonds.

Fidelity Convertible Securities (symbol FCVSX) is one of the most aggressive convertible funds. Manager Tom Soviero has about 15% of the fund in common stocks, and the converts he owns tend to trade close to their conversion price—meaning that they rise and fall mostly with the price of the stock.

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Performance in the two years since Soviero took over has been excellent -- 15% return in 2006 and almost 18% this year through November 8, according to Morningstar. And he has proven himself adept at managing junk bonds in his 17 years at Fidelity. At the same time, this fund is not designed to hold up particularly well in a bear market. The fund has returned an annualized 12.5% over the past ten years under several managers.

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Vanguard Convertible Securities (VCVSX) couldn't be more different from the Fidelity fund. Larry Keele of Oaktree Capital has managed the fund since its inception in 1996. He doesn't own any stocks. "Our fund is 100% converts," he says.

Keele takes a middle-of-the-road approach to the convert market—looking for converts that not only offer attractive yields bust also do well if the stock does well. "We lean a bit toward the bond end of the convertibles market," he says.

Over the past ten years through November 8, the fund has returned an annualized 9%. That's an average of one percentage point per year better than the Merrill convertible index. And Keele has put up that record with much less risk than the index. The fund shed less than 10% during the 2000-02 bear market.

Keele says converts can be a good addition to almost any portfolio. "If you don't know what the future holds, you should definitely own some converts."

Which fund to buy? If you're an investor who hates the thought of owning any bonds, go with Fidelity. Long term it should earn top-notch returns, as it has in the past.

But if you're looking for some shelter in this volatile market, Vanguard is the better choice. The Vanguard fund has a $10,000 minimum, but you can buy it for less through some online brokers.

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