Don’t Lose Your Balance…Funds, part I
by Richard
Today we will look at Hybrids.
Not the car. The funds.
Hybrids mix two, or more, divergent strategies in the same fund to dampen volatility and even boost returns in difficult markets.
These funds are found under the headings of balanced funds, alternative funds, hybrid funds or specialty funds.
We are going to take a look under the hood of convertible funds today, as they have held up with semi-respectable returns in this difficult year. Which means they are down, but not down as much as high-octane, equity-only funds.
The Trend for Hybrid Convertibles
Convertibles are a niche product. They are either bonds or preferred stock (itself a hybrid between a stock and a bond) that are convertible into the common stock upon reaching a pre-determined threshold.
If, for example, you had a bond convertible at a strike price of 50, that simply equates to your $1,000 face value bond having an exchange value of 20 shares of common stock, once that stock reaches $50 in value.
If the stock is now languishing in the high thirties or low forties, and you’re not comfortable stepping up to the plate and buying the common now, you can hedge your bet by buying the convertible.
The yield on the convertible bond may be in the 3-4% range, which is nearly double what your cash would earn in today’s money market environment, so you are paid an above market rate of return…especially compared to the common stock which may pay a tiny dividend, or more likely no dividend at all.
Now if you are in a Heads you win, and Tails you don’t lose much posture. If the stock breaks out, you exercise the conversion option. If it stays in the doldrums, you remain a debt investor with a steady coupon yield.
Driving Into Hedges
Hedge funds have glommed on to Convertible Arbitrage big time, and this causes extreme price movement. That is because it is pack of big dogs wagging a tiny tail. The total outstanding issuance of convertible securities in the U.S. is just a hair above $300 billion.
That sounds like a huge number, but hedge funds can employ leverage (the use of borrowed funds) to magnify their bets, and when you throw in all the hedge funds that have the ability to trade, this is a relatively compact playing field.
But you don’t have to go the hedge fund route, unless you have a predilection for high fees and long lockups and mediocre returns.
Mutual Fund Choices
There are a small number of mutual funds (21 according to Morningstar) that focus on this strategy. The low fee choice would be Vanguard Convertible Securities (VCVSX) with its 0.77% management fee, down just about 5% for the year, which is a strong relative return.
Another option is the Value Line Convertible Fund (VALCX), also a no-load fund available through most of the discount broker mutual fund supermarkets. It’s return to date is very close to the Vanguard Fund, with the big difference in fund size.
Value Line offers the advantage of its linkage to their stock and option research arms, and they are strong on fundamental analysis.
The Vanguard brand is so well known their funds tend to be sumo sized. Their convertible fund is nearly $1 billion in assets, while the lesser known Value Line Fund is a tiny $30 million.
I like the inherent flexibility and nimbleness that comes with the small fund. The can dart in and out of tiny positions easily, while the larger fund is often too muscle bound to take advantage of such small trades.
You should not subscribe to these funds with the belief that they will outperform in a bull market. They are designed to lag on the upside as well as to hold value on the downside.
They just help you cope with the extreme volatility that characterizes the current market.
