Get a Smoother Ride With Convertibles

A lot of the investors I talk with are nervous about the stock market. If you want to reduce your risk, convertible securities are an ideal solution. And Fidelity Convertible Securities fund (symbol FCVSX) is the best way to invest in this funky, but rewarding, market sector.

Lots of people steer away from convertible securities because of their complexity. As far as picking among individual converts, I agree: This is an endeavor best left to the pros. But you can hire a fund manager to do the heavy lifting for you -- and not worry about whether you understand all the ins and outs of converts.

The main thing you need to know about converts is that they're hybrids -- part bond and part stock. Like a bond, they pay you a fixed amount of interest. Like a stock, they rise and fall in price with the fortunes of the underlying company, especially with its common stock.

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Here's the good part: Convertibles typically have afforded investors more return than bonds with less volatility or risk than stocks. When the market goes up, converts do, too, though not as much. When the market heads south, converts lose money also but, again, not as much.

Over the past ten and 15 years, the average convertible fund has actually returned slightly more than Standard & Poor's 500-stock index. Over the past 20 years, the S&P 500 has done somewhat better, returning almost one percentage point more per year than convertible funds, on average.

What's not to like about a smoother ride than stocks, and roughly the same return? Of course, history doesn't always repeat itself. I'd expect convertibles to lag stocks over the next ten years, but not by much.

There are precious few funds that specialize in convertible securities. Morningstar lists only 20, and of these only eight are both open to new investors and levy no sales charges.

One fund stands head and shoulders above the rest: Fidelity Convertible Securities. Fidelity's stock funds generally haven't been so hot in recent years, but its bond funds have performed superbly. More important, Tom Soviero, who runs Convertible Securities, is one of the firm's most talented managers. He has delivered terrific returns as manager of Fidelity Leveraged Company Stock over the past four years. That fund has returned an annualized 34% over the past five years through May 29, making it one of the top-performing funds of any kind. Soviero, 43, has spent most of his 17-year career at Fidelity specializing in "junk" bonds and other high-yielding securities. He has managed Fidelity Advisor High Income Advantage, which also has an excellent record, since 2000. From June 2005, when Soviero became manager, through May 29, the convertible fund returned an annualized 21%. During that period, it has been the top-performing fund in its category.

Soviero runs Convertible Securities aggressively. Although the Merrill Lynch Convertible index is about half in investment-grade securities and half in junk-rated securities, Soviero's convertible fund is about two-thirds in low-rated credits. Soviero thinks the global economy has far more strength than some analysts believe. Consequently, he has loaded up on a few sectors that will do well only if he's right. Energy comprises 27% of the fund, technology is 21% and basic materials are 12%. "China and India are not slowing down," Soviero says. "I'm making a bet that energy will stay at a historically high level."

Soviero is being bold in other ways, too. He has about 16% of Convertible Securities's assets in common stocks. Stocks, of course, are riskier than convertibles. And Soviero is unafraid to back up the truck when he sees a convertible he likes. El Paso, a pipeline and oil-and-gas exploration company, and Celanese, a chemical maker, make up almost 15% of assets. The fund holds 110 securities, but the top 20 positions represent 55% of assets. "Risk is in the eye of the beholder," Soviero says. "I don't feel that this fund is more risky than its peers."

The convertible market has been infested in recent years by hedge funds, most of which trade at rapid-fire pace. Soviero's method for dealing with that is to avoid being short-term oriented. He typically holds a security for two to three years. "The people who are trading the market are playing a much different game," he says.

The math of convertibles is daunting. Each convertible can be converted into shares of common stock at a preset price. The relationship between the stock and the convert is complex. Soviero knows the math inside out, but "I don't get caught up in the math; I don't focus on it," he says.

Instead, he looks at converts one of two ways. In some cases, a stock has gone down so far that a convert trades like a bond -- that is, its price depends primarily on overall interest-rate moves and perceptions of the issuer's survivability. Soviero buys some of these high yielders for his fund. In other cases, a stock has gone up so far that the convert trades almost entirely like a stock. Soviero buys mainly the latter kind of convert. As a result, the fund yields a paltry 1.8% even though its expensive ratio is just 0.83%.

No matter what he says, Soviero's fund is riskier than most convertible funds. And he has yet to be tested in a bear market. But given the relatively low risk of convertibles, his fund is tame compared with most pure stock funds. In short, it's just the thing to tamp down the volatility of a stock-heavy portfolio.

Steven T. Goldberg (bio) is an investment adviser and freelance writer.