"Good Active Managers Are Out There"

If you have the time to do enough research, you might want to forego the index funds, says BW's Lewis Braham

The strong gains in many stocks and bonds recently have boosted returns of every kind of fund so far this year. Indeed, the positive performance of equity funds is welcome news after three years of losses. Some money managers, however, are a little concerned that stock prices have moved ahead too far too fast, notes Lewis Braham, personal finance editor of BusinessWeek.

Braham talked about mutual funds and how to pick them in an investing chat presented June 24 by BusinessWeek Online on America Online, in response to questions from the audience and from BW Online's Karyn McCormack. Edited excerpts follow. A complete transcript is available from BusinessWeek Online on AOL at keyword: BW Talk.

Q: Lewis, the latest mutual-fund data show a nice rebound after the dismal showings over the last three years. What do you make of the performances?


It certainly has been a sharp comeback, which has been impressive but a bit overwhelming to some of the money managers I speak to. Some of them are a bit cautious right now, saying that maybe the market has gotten ahead of itself, in particular in frothier areas such as technology and biotech stocks. That said, three down years do leave a lot of room for recovery.

Q: Bonds at this point -- yes or no?


Everybody should have some bonds in their portfolio, but I don't think you should be overweighting the sector right now. Bonds always add balance to a diversified portfolio, but the sector has rallied so much in the past three years that many consider bonds overvalued.

That said, a lot depends on the type of bonds you own. Treasury bonds arguably are the most overvalued and should probably be avoided except for of course the shortest maturities, which are really a cash equivalent. High-yield bonds were attractive at the start of this year but are also starting to reach points where some managers consider them overvalued. The one area that a number of managers consider undervalued is municipal bonds.

Q: If we're going into deflation, what is the best way to protect your investments?


That's a good question. Cash works very well for a deflationary environment, simply because if you're getting 2% from your bank account, or 3% from a CD, you're still going to be ahead of prices when they're falling. Arguably, Treasury bonds also work during a deflationary environment. But as I said before, they're fairly overvalued right now.

Bear-market funds that short stocks would also do well in a deflationary environment. And, if you can find stocks in industries that are relatively resistant to deflation -- health care, education, and insurance -- these might be worthwhile sectors to look into.

Q: Doesn't the new tax law on dividends favor stocks over high-yield bonds?


You could argue that, but remember, the average stock in the S&P 500 is still yielding only about 1.5%. Meanwhile, in high-yield bonds, you can get 8% or 9%, or even more. That spread is wide enough to make high-yield still seem attractive on a relative basis. On top of that, they really are different asset classes.

Bonds are higher up in the capital structure of companies. Which means if a company goes bankrupt, you're more likely to get your money back, or some of your money back, from the bond than you will from the stock. You probably should own a little bit of both.

Q: What is your view on hybrid funds such as Oakmark Equity & Income Fund (OAKBX )?


I'm a big fan of hybrid funds in general. I think too much emphasis has been placed on sticking to a narrow slice of the style box for mutual funds. And giving a good money manager the freedom to invest anywhere can add to returns on the upside and protect investors from losses on the downside.

The Oakmark Fund has an excellent record, but I am a little concerned about its asset size right now. Last time I checked, it has close to $3 billion in its coffers. That may limit the fund's flexibility. But there's no denying that the managers at Oakmark have an enviable record.

Q: Can you name a couple of good hybrid funds?


Leuthold Core (LCORX ), Evergreen Asset Allocation (EAAFX ), FPA Crescent Fund (FPACX ), and First Eagle Global Fund (SGENX ) are pretty good choices.

Q: What do you think about John Bogle's advice -- own a total market index fund and forget picking the hot manager?


For investors who don't have time to look at their portfolios regularly -- at least once a quarter or once a month -- I think that's decent advice. But for people who really pay attention, I don't agree. Good active managers are out there, and if you look for them hard enough, you can find them. And if you also pay attention to expenses and the asset size of the funds, you may stand a good chance of beating the index.

What's more, the total market index funds are top-heavy with the largest stocks in the U.S. stock market. If you don't think those are going to be the stocks that will outperform going forward, you won't be diversified enough in other areas.

Q: How do we judge whether a fund's outlook is prosperous or bleak?


You can make a top-down judgement about a sector or an asset class to determine a fund's prospects. So if large-cap growth stocks look good, chances are large-cap growth funds in general will do well. But then there are certain fund-specific things to look at. Low expenses are always an advantage, few assets are usually an advantage, management investment in the fund helps, and then the manager's track record overall at the fund helps.

One of the things to look at is what you call risk-adjusted returns, which you can find in BusinessWeek's Interactive Mutual Fund Scoreboard where funds are rated A through F based on their five-year risk-adjusted returns. These returns are important because they show that a manager has a performance edge not just because he's investing in the most volatile asset class of the moment but because he can generate excess returns above the risk level that other managers take who generate lower returns.

Edited by Karyn McCormack

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