Consider mutual funds that limit volatility

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Mark Jewell

The best move for an investor suffering from stock shock might be to stick with the market. But do it in a way that takes some of the edge off its ups and downs.

If you want smoother investment returns, put your money in a bond mutual fund. But don’t forego stock funds whose managers strive to reduce volatility.

A few have consistently delivered on that difficult-to-achieve goal. And they’ve done so without giving up too much of the greater long-term earnings potential of stocks versus bonds.

That’s a particularly appealing approach for investors in or near retirement. They may be living off of their savings, rather than building them up, so they’re not in position to wait long for stocks to rebound from a rough patch.

“Volatility, in and of itself, is not bad if you’ve got enough time to make up for it,” said Harry Milling, a fund analyst with Morningstar. “If you don’t, then a low-volatility strategy is really important.”

It’s easy to see why investors are wary of stocks now. Last month, the Standard & Poor’s 500 index whipsawed at least 4 percent for four consecutive days — two days up, two down. By late August, the index was down 6.4 percent for the year.

That drop helps explain investors’ net withdrawal of $40 billion from mutual funds in a single week in August. It was the biggest such exit in nearly three years. Three-quarters of the amount withdrawn came from stock funds.

Finding safer stocks

In a market like this one, stock funds that specifically pursue strategies to limit volatility tout any success they’ve had achieving that goal.

They use a wide range of approaches — from investing in dividend-paying stocks of companies that typically offer greater stability than growth stocks, to buying half-stock, half-bond hybrids called convertibles.

Yet there is a downside. When stocks rally, low-volatility funds are likely to underperform peers taking less-constrained approaches.

“You give up a little on the upside, in order to save you on the downside,” Milling said. “But over time, that approach often ends up winning the race.”

Below are six low-volatility funds that are among Milling’s favorites. Each has either a top-rung 5-star or 4-star rating from Morningstar. Those ratings are based on past performance, and the level of risk taken to achieve investment returns.

Over the long-term, each fund has demonstrated lower volatility than its peers — based in part on downside and upside “capture ratios.” Low-volatility funds with good downside capture ratios consistently suffered smaller losses than the S&P 500 when stocks declined.

Conversely, during rallies these funds captured most of the gains, or in some instances beat the market. Those are among the volatility measures found on Morningstar.com by clicking on a fund’s “risk & ratings statistics” tab.

The downside capture ratio is of particular interest in this market decline. The sell-off offers a fresh but painful reminder of the realities of recovery math. If your stock portfolio loses 50 percent of its value, you’ll need a 100 percent gain — not 50 percent — to get back to where you started.

Six low volatility funds

  1. American Century Equity Income (TWEAX): This large-cap value stock fund invests in dividend-paying companies best positioned to weather tough times. Managers also invest in convertible bonds, which offer the option of converting into the issuer’s common stock at a predetermined price.
    Convertibles provide the safety of a bond along with an opportunity to profit if the company’s stock rises in price. Over the past 15-year period, this fund has earned 70 percent of the S&P 500’s gains, while suffering just 49 percent of its declines.
     
  2. BlackRockEquityDividend (MDDVX): This large-cap value fund invests at least 80 percent of its assets in dividend-paying stocks. Over the past 15-year period, the fund has captured 79 percent of the market’s gains, while suffering 63 percent of its declines.
     
  3. CalamosGrowth&Income (CVTRX): This aggressive allocation fund holds a mix of stocks, bonds and convertibles. Over the past 10-year period, the fund ranks in the top 3 percent among its peers, with an average annualized return of nearly 6 percent.
     
  4. LKCMEquityInstitutional (LKEQX): Milling considers this large-cap blend fund a hidden gem. It’s got a 5-star ranking, yet is relatively small, with $89 million in assets. Over the past 10-year period, it has captured 95 percent of the market’s gains, while suffering 87 percent of its losses.
     
  5. Queens RoadSmall Cap Value (QRSVX): With $56 million in assets, this small-cap value fund remains small despite its top rating. Its performance surpassed the overall market over the last 5-year period, capturing 104 percent of the gains, while suffering 88 percent of its losses. By keeping as much as 21 percent of its assets in cash, its managers have helped limit recent losses.
     
  6. Royce Special Equity Investment (RYSEX): This well-known small-cap blend fund has captured 102 percent of the market’s gains over the last 10-year period, while suffering only 66 percent of the market’s losses.

— AP