NEW YORK (TheStreet) -- In recent years, convertibles funds have delivered compelling returns. During the past decade, the funds returned 6% annually, outdoing the S&P 500 by 2 percentage points while taking much less risk, according to Morningstar. Can convertibles continue outpacing stocks? Maybe not. But convertibles are worth considering because they can diversify portfolios.
Convertibles are bond-like securities that can be converted to stocks. Yields on the securities currently range from about 2% to 5%. The yields cushion performance in downturns. As a result, convertibles outdid the S&P 500 during the market collapses that occurred after the Internet bubble burst in 2000 and in the financial crisis of 2008.
Convertibles come with a variety of different characteristics. At one end of the spectrum are volatile securities that track stocks closely. At the other extreme are bond-like securities that rise and fall with fixed-income markets. Many top-performing funds favor balanced convertibles, which fall in the middle of the range and have characteristics of both bonds and stocks. Balanced securities tend to avoid big losses in downturns and record decent gains in bull markets.
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For a solid fund that focuses on balanced securities, consider Franklin Convertible Securities , which returned 6.9% annually during the past 10 years, outdoing 86% of peers. Franklin portfolio manager Alan Muschott looks for convertibles that would only lose half as much as stocks in downturns and deliver 75% of the gains in rallies. Muschott avoids convertibles that track equities too closely. Such securities can excel in rallies, but they can also suffer steep losses in downturns. "We prefer the balanced securities because they have favorable characteristics on the upside and the downside," he says.
Muschott said that the characteristics of convertibles can change. Sometimes a balanced convertible can begin to act more like equities. When that happens, Muschott sells. To appreciate why his strategy can work, consider that in a typical deal an investor might pay $12,000 for a security that can be converted into stock worth only $10,000 today. The premium is justified because convertibles can pay off under a variety of scenarios. If the stock skyrockets, an investor can convert the security to common shares and record a nice gain. If the stock goes nowhere, the investor still collects fixed yields, which are typically higher than stock dividends.
Now suppose the stock climbs. The price of the convertible will rise, and the yield will drop. It will soon pay to change the convertible into stock, and investors will begin viewing the security as an equity substitute -- not as a balanced convertible. In a rising market, an equity-like security will outdo a balanced convertible. But if the market collapses, the equity-like security can drop sharply and trail balanced securities.
To limit risk, Muschott sells securities as they become more equity-like. He shifts assets back to balanced convertibles. As a result, the fund is constantly selling high flyers and buying middle-of-the road choices. Muschott says that the strategy tends to make the fund steadier and boost returns over the long term. "Toward the end of a bull market, we tend to be selling equity-sensitive securities, and that provides protection," he says.
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Muschott also steers away from depressed securities that are known as busted convertibles. Investors have abandoned hope that the busted securities will ever appreciate and make a conversion profitable. As a result, the securities trade like bonds. While the busted securities can pay nice yields, they tend to lag during bull markets.
Another fund that focuses on balanced convertibles is Allianz AGIC Convertible . During the last 10 years the fund returned 8.2% annually, outdoing 97% of peers. Portfolio manager Justin Kass likes to find issuers that are improving profit margins and beating earnings estimates. Lately he has been favoring semiconductor companies. A holding is an issue from Micron Technology MU . Last year, the semiconductor companies did poorly as investors worried about oversupplies and sluggish sales of personal computers, Kass says. But lately the picture has been improving. "Inventories are coming down, and the PC market is starting to recover," he says.
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A relatively steady fund is MainStay Convertible , which returned 6.3% annually during the past 10 years, outdoing 66% of peers. Portfolio manager Edward Silverstein looks for balanced securities from companies with healthy balance sheets and strong free cash flow. A favorite holding is an issue from Apache APA , an independent producer of oil and gas. The security yields 6% and should provide 80% of the upside of the stock. "The stock is undervalued, and the company has strong cash flow," says Silverstein.