From the June 2008 issue of Wealth Manager Web • Subscribe!

June 1, 2008

Hanging In

It is hardly surprising that even in the recent market turmoil, convertible securities proved resilient. During the 12 months ending in February, convertible funds returned 1.1 percent, while the Standard & Poor's 500-stock index lost 3.6 percent. Since convertibles are fixed-income vehicles that can be converted to common stocks, their hybrid features often enable them to deliver equity-like returns while suffering limited losses in downturns. Top convertible funds have recorded a feat that is unusual in the investment world: They can outdo the S&P 500 over long periods, while achieving lower standard deviations than the benchmark has recorded.

In addition to providing a cushion in hard times, convertibles can be appealing in calmer markets, too. Because they don't move in lockstep with either stocks or bonds, these hybrid securities can offer important diversification. By adding a convertible fund, investors can prepare their portfolios for downturns and still be positioned to benefit from any market rebound.

Which convertible fund is the best choice? To make a selection, Wealth Manager again turned to the eight-part screens developed by Donald Trone, chief executive of FI360, a consulting firm in Sewickley, Pa. Trone's due-diligence process seeks funds that have more than $75 million in assets and are at least three years old. One- and three-year total returns must exceed the category medians, as must five-year results if the fund is that old. Alphas and Sharpe ratios must also surpass the medians. The expense ratio must fall below the top quartile, and at least 80 percent of the fund's holdings must be consistent with the category.

The screens reduced the field from 61 down to 8. Strong finishers included Vanguard Convertible Securities, Davis Appreciation and Income and Putnam Convertible Income-Growth. We awarded the title to Fidelity Convertible Securities, which posted the top five-year returns among the finalists.

Fidelity portfolio manager Tom Soviero won the title by sticking with solid companies that generate plenty of free cash flow. His aim is to find issuers that seem likely to improve their cash flows during the next 12 to 36 months. The catalyst for increasing cash flow could be a new product or a global economic trend. "I prefer companies that have the wind at their backs," Soviero says.

Seeking to fill its portfolio with the most promising convertibles, the Fidelity fund is willing to depart from his benchmark-- underweighting or overweighting certain industries. In recent years the fund has been underweight the financial sector, a prescient call that protected shareholders from losses. "Two years ago, it seemed that financial companies were sowing the seeds of future problems," says Soviero. "Money was too easily available for questionable investments."

The fund also produced good results by overweighting energy issues. Soviero believed that strong demand from emerging economies would keep prices of energy high for years. A big holding is a convertible from El Paso Corporation, which produces natural gas and operates pipelines. Selling assets, the company has paid down debts. And even if gas prices fall, El Paso should enjoy steady revenues from its reliable pipeline business, Soviero says.

Another holding is oil and gas producer Chesapeake Energy. After growing through a series of acquisitions, the company is now focused on cutting costs and developing its assets, a strategy that should raise profits.

A holding that should benefit from growth in the emerging markets is Celanese, a maker of industrial chemicals. The company recently opened a plant in China that should help increase revenues.

Celanese and most other issues in the Fidelity portfolio fall at the extreme of the convertible spectrum. These issues act much like stocks, rising sharply when a company's common stock climbs. Soviero steers away from issues that fall toward the middle of the spectrum and only provide moderate appreciation potential.

To understand why Soviero favors equity-like securities, consider a typical deal where an investor might have paid $1,200 for a convertible that can be swapped for 100 common shares currently worth a total of $1,000. If the common stock doubles from $10 to $20, the equity-like convertible price might climb to $2,000, and the investor could book a nice profit. In the example, the convertible enables the investor to obtain 80 percent of the upside of the common stock. Why pay the steep price for the convertible instead of just buying the common stock? The convertible offers downside protection. If the common stock languishes, the convertible price may also stay flat. But the convertible investor need not have regrets. While holding the convertible, he can collect a bond-like yield of more than 5 percent. In contrast, the common shares may pay little or no dividends.

By emphasizing convertibles that rise along with the common, Soviero has outpaced competitors that buy more moderate convertibles. These milder convertibles may offer safety, but they could be priced so that an investor can only get 50 percent of the upside potential of the common stocks.

While Soviero rarely takes convertibles that offer only moderate upside potential, he sometimes buys bond-like issues known as busted convertibles. In a typical busted deal, the price of the common stock may have dropped from $10 to $3. The convertible price would have fallen along with the common shares. Under these conditions, there is little chance that the convertible price would ever rise to the point where the issue could be swapped profitably for common stock. Although busted issues offer little potential for capital appreciation, they currently pay yields of more than 10 percent. That rich income stream could help Soviero deliver the kind of solid returns that Fidelity shareholders have come to expect.

Stan Luxenberg (sluxenberg1@nyc.rr.com) is a New York-based freelance business writer and a longtime regular contributor to Wealth Manager.

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