The Worthy

Back during the buying panic of the 1990s, it was fashionable to believe: “Sell your losers, and run with your winners.” Of course, one of the lessons of the subsequent crack up: Don't let your winners run so much that they dominate your portfolio. Sure, it's good fun while they trot. But if the bottom begins falling out, as it did in March 2000, you're in deep trouble.

It seems that lesson has been lost; advisors and their clients are once again chasing the hot dot. Tired of lackluster performance, investors have been ignoring large-cap domestic funds. Instead, foreign funds are all the rage: During the first eight months of 2005, foreign funds attracted $95.1 billion in new assets, more than double the figure of domestic large-cap funds. The slow sales can be traced to weak returns for domestic large-cap funds. Over the last five years, categories like large growth and large blend have remained in the red, with active managers trailing the benchmarks. Recognizing the sorry results, plenty of investors are shifting to small-caps or trying exchanged-traded funds as ways to handle large-cap allocations.

But, there are still good reasons for many investors to consider active large-cap managers. For starters, blue-chip funds provide exposure to an asset class that every portfolio should own. Just as important, active funds have proved effective at controlling risk. Top-performing managers have shown that they can consistently deliver less risk than their benchmarks, as measured by standard deviation — a measure of how much a fund's returns bounce up and down compared to average results. While the S&P 500 has a standard deviation of about 13.10, plenty of large blend funds record figures of less than 12. This is no insignificant feat. At a time of erratic markets, funds with low standard deviations produce smoother rides and lose less in downturns. Just as past returns may not predict future results, past risk measures have limitations, but the risk measures can provide some guidance. Standard deviation tends to be relatively consistent in funds of all kinds. “If a fund had low standard deviation in the past, then there is a pretty good chance that it will have low standard deviation going forward,” says Peng Chen, chief investment officer of Ibbotson Associates.

To evaluate risk-adjusted returns, many advisors consider the measurement known as alpha, an indicator of a fund's returns considering the risk it assumed. Funds with positive alpha have produced higher returns than would be expected by the market risk they take. Ranking funds by alpha, Ibbotson found that those in the top 5 percent went on to produce positive alphas in 16 of the 22 years ending in 1999, a much better showing than funds that produced weaker alphas.

With Ibbotson's research (and others, too) in mind, we set out to find funds with top risk-adjusted returns during the past five years. Our aim was to locate champions that could continue their winning ways, even if their sectors were out of favor. To succeed in the future, we figured, funds would need risk-control techniques that could be maintained year after year. The presence of a clear strategy would provide some comfort that a fund had succeeded through skill, not luck. “Not many funds are consistent performers, but that is what clients usually prefer,” says Pran Tiku, president of Peak Financial Management, a registered investment advisor in Waltham, Mass.

Large Blend

A strong performer in the large blend category is Exeter Pro-Blend Max A. While the average member of the category had an alpha of -0.07, Exeter reported a figure of 4.95. The fund had a Sharpe ratio of 1.14, well above the category average figure of 0.78 (for definitions, see prior story). Most important, Exeter excelled in a variety of conditions. In the down year of 2000, Exeter returned 19.2 percent, 23 percentage points ahead of the category. During the rebound of 2003, Exeter returned 29.5, two percentage points ahead of the category.

To control risk, Exeter owns a diversified mix of moderately priced stocks, including some that might be labeled growth and others that could fall into the value camp. The managers like to grab blue-chip growth stars when prices have slipped. A big holding is Cisco Systems, the giant producer of routers and other equipment used for the Internet. “We can only buy a growth name like Cisco when we feel it is selling at a 20 percent or 30 percent discount to its fair value,” says Jeffrey Coons, research director of the fund.

To limit risk, Analytic Defensive Equity A sells covered calls. Why bother selling covered calls? If the stock goes nowhere, the fund gets to keep the stock and pocket the option premium. The strategy is particularly effective in hard times. The premium cushions downturns and provides income when stocks are going nowhere. “In flat or down markets, we can outperform the benchmarks,” says Harindra De Silva, portfolio manager.

Income from the calls helped the fund record a high alpha of 7.36. But the downside of selling calls is that the fund gives up the right to benefit from all the gains achieved in a bull market. Analytic rarely finishes first in strong bull markets.

Another way to thrive in downturns is by sticking with very high-quality companies. Such resilient companies tend to stay afloat when other stocks sink. Buying strong competitors is the approach of Tocqueville Alexis, which seeks companies with healthy balance sheets and high returns on capital. Typical holdings show earnings growth rates of around 10 percent. Portfolio manager Colin Ferenbach seeks to buy quality companies when they have fallen out of favor. A recent purchase is 3M, the maker of Post-it Notes. The company once sold for a price/earnings multiple of more than 40, but now commands a P/E multiple of 18. “This company continues to be innovative and grow at an above-average rate,” says Ferenbach. “There is nothing wrong with this stock. The market seems to like riskier stocks instead of steady growth stocks. I don't know what people could be thinking.”

Ferenbach recently bought Microsoft, a stock that has seen its earnings growth slow down from the glory days of the 1990s. “The multiple is down, but this is still a better business than 90 percent of the companies in America,” he says.

Large Growth

Investors seeking a growth fund with some oomph should consider Brandywine Blue. The fund typically seeks companies that are increasing earnings at annual rates of 20 percent or more, yet the portfolio has a P/E of 16, well below average for the category. By keeping a close rein on valuations, the fund has managed to produce an impressive alpha of 8.1 and a standard deviation of just 12.72. Portfolio manager Bill D'Alonzo specializes in unappreciated businesses that are poised to surprise analysts. “We love to find the instances where the seventh biggest company in an industry is making a move to the No. 3 spot,” he says.

A recent holding is Coventry Health Care, an insurer. The company has been increasing earnings at a 30 percent annual rate, yet the P/E is just 14 times estimated earnings for 2006, says D'Alonzo. Coventry has been successful at buying weak regional insurance plans and raising their profits. That has resulted in a string of earnings surprises.

Another high-powered growth choice is Fidelity Capital Appreciation, which delivered a strong alpha of 4.9. Portfolio manager Harry Lange holds a mix of growth stocks, including fast growers with P/Es of more than 30, and slow-moving choices with multiples in the teens. The diversification helps keep the portfolio somewhat stable and enabled the fund to outdo competitors in the down year of 2001, as well as the friendlier climate of 2003. While Lange is willing to pay steep prices for rapid growth, he draws the line at multiples that seem excessive. “We wouldn't pay 100 times earnings, but we will consider a fast-growing stock with a multiple of 40,” he says. An example of a growth holding is Genentech, and a “slower grower” is Univision Communications, a Spanish broadcaster that is showing double-digit earnings gains as it exploits an expanding market.

Growth investors who seek a steady performer should consider Transamerica Diversified Equity. The fund pays modest prices for blue chips with staying power. “We are interested in finding great companies at a fair price, not a value price,” says portfolio manager Gary Rolle.

A patient investor who often holds stocks for five years or more, Rolle hopes that companies gradually increase their earnings so that the initial stock price begins to appear cheap. That stable approach has resulted in an alpha of 2.55. The fund's biggest holding is Plum Creek Timber, which owns seven million acres of forest. Profits have grown as steadily as the trees, and the company has enjoyed reliable cash flow as it harvests its timber.

For a diversified pick, consider Dreyfus Premier Alpha Growth A. The fund uses several different quantitative screens to pick groups of stocks that don't move in the same direction. Of the approximately 50 names in the portfolio, some are selected because they have been showing strong appreciation in the past six months. Other stocks make the cut because they have high forecasted growth rates. Portfolio manager James O'Shaughnessy began developing screens in the 1990s when he published the best-selling What Works on Wall Street (McGraw-Hill, 1998). His Dreyfus fund aims to produce decent returns, even when the large growth category is out of favor. “What we are trying to do is get a system where we always have something working in the portfolio,” he says.

Large Value

A value player with high returns and minuscule standard deviation is American Century Equity Income. The fund keeps volatility low by emphasizing stocks with above-average dividends. Such high-yielding investments tend to hold up in downturns when investors flock to safer securities. For an extra cushion, the fund usually holds some convertibles, securities that offer comfortable yields and some downside protection.

The fund only buys stocks with below-average P/E multiples. Often the holdings are companies with stable records that appear to face temporary problems, such as Kraft Foods. Rising commodity costs are hurting margins, but manager Phil Davidson reckons that the company will revive in a year or two. “Kraft is so strong financially that it can eventually adjust to the markets and begin increasing earnings again,” he says.

Another bargain shopper is Pioneer Cullen Value A, which typically takes stocks with P/E ratios of 15 or lower. To stay diversified the fund puts no more than 15 percent of assets in any one industry.

Pioneer seeks stocks with the potential to deliver earnings gains. A favorite holding is J.P. Morgan, which has suffered disappointing earnings. Pioneer portfolio manager Jim Cullen is betting that Jamie Dimon, who has been tapped for chief executive, will be able to execute a turnaround. “Jamie Dimon is a great cost-cutter who should bring new efficiency,” says Cullen.

Cullen is particularly interested when a stock declines and suddenly becomes cheap enough for him to consider. Recently Hewlett-Packard took the plunge as investors worried about weak earnings. But now with a new chief executive at the helm, Cullen figures that the company will revive.

For value investors who seek a rich alpha, and are willing to take on some risk, Yacktman Fund may be a solid choice. The fund seeks steady businesses with high returns on assets. When portfolio manager Donald Yacktman finds a favorite, he jumps in, often putting more than 40 percent of assets in his top 10 picks.

The largest holding is currently Coca-Cola, which accounts for more than 7 percent of the fund's assets. Yacktman concedes that the soft-drink maker has produced disappointing profits, but he figures that things will change. Fast growth in emerging markets should help fatten margins. “This is a money machine that needs a little oiling,” he says.

Many Healthy Returns