(The author is a Reuters contributor. The opinions expressed are his own.)
By Lewis Braham
PITTSBURGH, March 21 Freedom for money managers is a double-edged sword. Nothing highlights an active manager's skill, or lack thereof, like flexibility. If you can buy any stock or bond, your opportunities to soar above your peers or crash and burn increase dramatically.
The Lipper 2014 U.S. Fund Awards for the "mixed-asset" and "flexible portfolio" categories highlight the abilities of the best go-anywhere managers. They must not only outperform on returns but also assume the same or less risk than their peers. Lipper is a unit of Thomson Reuters Corp .
Since the funds are so flexible, figuring out where they belong in your portfolio can be tricky. Are they bond substitutes, equity substitutes, or a little bit of both? It's hard to say, because strategies vary tremendously.
At Villere Balanced, a winner in the Mixed-Asset Target Allocation Growth category, co-managers George Young and Lamar Villere employ a bottom-up, kick-the-tires approach, seeking stocks and bonds of undiscovered, often small, companies.
Meanwhile, Kandarp Acharya, co-manager of Wells Fargo Advantage Index Asset Allocation and winner in the Mixed-Asset Target Allocation Moderate category, uses a more top-down, macro approach to determine how to allocate to indexes of large-cap stocks and Treasury bonds.
The Wells Fargo fund is up an annualized 17.7 percent during the past five years through March 19, besting 97 percent of its peers. Villere Balanced is up an annualized 22.7 percent for the same period, outperforming 99 percent of its peers.
WORKING WITHIN LIMITS
Most flexible fund managers have some allocation restrictions, but usually have a lot of leeway within the limits. The Villere fund, for instance, can hold anywhere between 25 percent and 40 percent in bonds. Right now, it has 27 percent.
"We're fairly negative on bonds with interest rates so low," Young says.
The fund is also fairly concentrated, holding only 25 stocks. Young of Villere likes companies unknown to most investors, like LKQ Corp, which has a 70 percent market share in the refurbished auto parts market. LKQ Corp has many of the features he seeks in a stock: a dominant position in its industry, strong cash flow and manageable debt levels.
By contrast, Wells Fargo's Acharya says markets are reasonably efficient, so indexing makes sense, given the difficulty most managers have beating their benchmarks. Actively managing the allocation to various assets can add value, he noted.
The academic research bears him out. According to studies, some 40 percent of portfolio performance at the average fund was due not to individual stock picking but to how much was in stocks or bonds.
Acharya determines his allocations in part through a quantitative model that compares the relative prices of stocks to bonds. If price-earnings ratios of stocks are reasonable while bond yields are skimpy, as they are now, the fund tilts toward stocks.
But models can be misleading if you rely solely on them. So once a month, Acharya convenes an eight-member investment committee that includes the firm's top investment team, such as Jim Paulsen, the chief investment strategist.
Most of the other Lipper winners with flexible styles resemble Villere's bottom-up approach, but with important differences. Take John Nichol, lead manager of the Federated Capital Income Fund, winner in the Mixed-Asset Target Allocation Conservative category. While he can buy virtually any asset, Nichol's fund must always be at least 50 percent in bonds but can go as high as 75 percent in that asset class. He has delivered a 7.4 percent annualized return over the past decade, besting 97 percent of his peers.
Right now, Nichol has almost one-half of his portfolio in high-yield and emerging-market bonds, which are paying the best yields and are the least sensitive to interest-rate increases. Instead of picking individual securities in those sectors, he invests in other funds run by Federated bond managers and focuses on stocks with his own analyst team.
Most equity-income investors tend to go heavily in utility stocks with high dividends. Nichol is flexible there, too. He will often switch between a high-dividend strategy and a dividend-growth view, buying stocks with dividends that may be low but increasing.
BEHAVING LIKE BONDS
In a rising interest-rate environment, high-dividend stocks usually fall as they behave like bonds. Last May and June, when rates jumped by more than one percentage point, Nichol was underweight in utilities as he saw them as overvalued and was overweight in dividend-growth pharmaceutical and technology stocks. This minimized losses and enabled the fund to beat more than 90 percent of its peers in 2013.
Now that high dividend payers have fallen some, Nichol is easing back into the sector. The fund has 21 percent in energy stocks like Royal Dutch Shell and ConocoPhillips , which have yields in excess of 4 percent.
While Federated Capital Income has an income tilt, Columbia Marsico Flexible Capital slants toward equities, requiring it be at least 60 percent in stocks. As the winner in the global flexible portfolio category, it has 94 percent of assets in stocks, but bonds have been as high as the teens, when yields were in the double-digits in 2009.
Although stocks dominate now, part of the strategy of Flexible Capital, according to co-manager Munish Malhotra, is to examine the entire capital structure of a company to find the best value. A holding like AutoZone Inc, which sells replacement vehicle parts, pays only 3 percent to 4 percent yields on its bonds, but is using the debt to buy back stock at a significant rate. The buybacks equate to an 8 percent dividend yield in Malhotra's calculations so he feels the stock is the better deal than the low paying bonds.
Figuring out where these eclectic funds belong in your portfolio can be tricky. But given the skills of these managers, it's worth making room for them somewhere. (Follow us @ReutersMoney or here; Editing by Lauren Young and Jeffrey Benkoe)