A Rocky Market's Steady Performers

How these funds are playing defense

Not that long ago, investors complained if their mutual funds didn't deliver double-digit returns--every month. Now they feel lucky if their funds don't fall every day. With the average domestic equity fund down 23% this year, the priority for investors is making a little money without taking huge downside risk.

BusinessWeek's Mutual Fund Scoreboard can help in this department. This fund tool, updated monthly and available at www.businessweek.com, ranks funds on their five-year total returns adjusted for downside risk and rates them from A to F. So funds that have high returns, but are subject to volatile downswings, often won't score as well as those that have lower returns but offer a much smoother ride. Only the top 7.5% of the more than 3,400 equity funds and 1,600 bond funds the scoreboard rates receive A grades.

Since our last ratings review (BW--Jan. 28), the A-list has seen a number of significant shifts. Of the 160 A-rated equity funds, 60 are newcomers (table). Of those, 42 are small- and mid-cap funds. Many large-cap stalwarts, such as Growth Fund of America (AGTHX ), Janus Growth & Income (JAGIX ), and Fidelity Dividend Growth (FDGFX ), have fallen off. That should be no surprise given the bludgeoning of the big tech, telecom, and even pharmaceutical stocks they own.

Large-cap growth funds are doing poorly relative to all funds, but there's a way to see how any fund is performing relative to its peers. That's the category rating, in which the calculation is the same as the overall ratings, but the comparison is just among like funds. So even if a fund no longer merits an A rating overall, it can be top-rated within its fund category.

What's most interesting is a fund that gets an overall A rating even though it invests in an out-of-favor sector. Two such funds, Julius Baer International Equity (JIEIX ) and Artisan International (ARTIX ), made it to the top even though overseas markets trailed the U.S. for most of the last five years. Both got As in category ratings, too.

How do they do it? Baer portfolio manager Richard Pell says he reduces risk through diversification--the fund typically has at least 150 holdings in 25 countries--but also by applying different strategies for different countries. In developed European nations, he analyzes the company's business model first and considers the country's economic condition second. In emerging markets such as Brazil and Taiwan, he uses the reverse approach because stocks there react more strongly to economic factors. "If we don't like an emerging country, we won't buy a single stock there, no matter how cheap it is," he says. This has kept him out of Latin America since Argentina's economic crisis began, while other managers have suffered big losses there.

Some large-cap managers have retained their As by playing defense. PBHG Large Cap Value Fund (PLCVX ) kept its grade by investing primarily in companies with strong, clean balance sheets. Manager Raymond McCaffrey has also been bulking up on Baby Bell stocks such as Verizon Communications (VZ ), SBC Communications (SBC ), and BellSouth (BLS ), which pay relatively high dividends. "Unlike earnings, dividends can't be manipulated by accountants," he says. The dividend also acts as a cushion against stock slides. McCaffrey's fund has taken a hit this year from bets in the pharmaceutical sector, but his overall record is sound.

Funds that are not tethered to a specific sector of the market can use that flexibility to temper risk. John Thompson runs the A-rated Thompson Plumb Growth (THPGX ), which is an all-cap fund that can invest in companies of any size. Two years ago he was 50% invested in small-caps, as they were much cheaper than large. That helped buoy him during the blue-chip bear market, but now he has shifted 70% of his assets to large-cap stocks. "When small-caps are valued the same as large, we migrate to large," he says. "Blue chips are more seasoned companies with more barriers to entry for competition."

In the small-cap sector, the funds that buy stocks with market caps less than $300 million are shining. "These stocks fly beneath the radar screens of institutional investment firms and brokerage analysts," says Bruce Baughman, portfolio manager of Franklin MicroCap Value Fund, up 5% this year. He controls risk with a classic value strategy: Buy stocks so cheap there's little room for them to fall. Says Baughman: "When you buy a dollar's worth of assets for 80 cents, you have an extra margin of safety."

The stocks small-cap growth funds buy never look cheap at the time of purchase. They're only cheap in hindsight if the stock pays off big. So how do those funds limit risk? They make sure a stock with high earnings expectations priced into its shares can meet them. "There are businesses reporting profits right now, which after you adjust for the cost of stock options, are at a loss or significantly more expensive than they would appear on the surface," says Transamerica Premier Growth Opportunities (TPSCX ) portfolio manager Kenneth Broad. Although his fund has been hurt by the sell-off, it has outperformed its peers.

There are even three A-rated tech funds--Icon Information Technology (ICTEX ), Kinetics Internet (WWWFX ), and Waddell & Reed Adviser Science & Technology. All are down sharply this year, but if the sector rebounds, don't be surprised if these three lead the charge.

By Lewis Braham

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