When markets collapsed during the financial crisis, many investors became furious at their financial advisors. The advisors should have dumped stocks, the clients argued. But throughout the turmoil, many advisors counseled clients to stay the course, maintaining portfolios while stocks sank. Citing time-honored views, the advisors said that it is a mistake to bail out of markets during downturns. Instead, investors should hold on and wait for the inevitable rebound.
While there is a strong case for the buy-and-hold approach supported by many advisors, a growing number of flexible mutual funds follow a different strategy—selling stocks and shifting to cash when conditions look hazardous. The funds do not have perfect timing. In some cases, managers have been caught holding cash when stocks were rallying.
In general, however, the funds have tended to excel in downturns and deliver decent returns in good times. That has produced strong long-term returns. Should you put all your assets in a flexible fund? Probably not. But by including a cash-holding fund, you may help to diversify your portfolio and limit losses in downturns.
One of the top-performing funds during the financial crisis was Stadion Managed Portfolio. While the S&P 500 lost 37.0% in 2008, Stadion only declined 5.8%. The fund avoided much of the damage by holding a big cash stake. The portfolio managers divide the markets into sectors, such as finance and technology. If technology stocks are rising, the fund takes a position in the sector. When a sector begins falling, the managers sell the stocks and shift to cash. “We want to own securities that are performing well right now,” says portfolio manager Brad Thompson.
During the first week of April this year, the market began slowing, and the fund shifted to cash. At first the move seemed untimely because stocks continued rising. Then markets sank sharply as investors worried about the continuing crisis in Europe. During May, the S&P 500 lost 6%, while Stadion about broke even.
Among the strongest performing funds has been Columbia Thermostat, which has returned 3.8% annually during the past five years, while the S&P 500 lost 1.5%. The fund follows a simple formula that aims to buy stocks when they are cheap and sell when prices look rich. The formula is based on moves in the S&P 500, which was recently around 1400. When the index is below 1000, Thermostat becomes bullish, putting 90% of assets in stocks. As the S&P rises, the fund sells stocks and shifts to bonds and cash. When the index rises above 1750, the fund will have only 10% of assets in stocks. The portfolio recently had 50% of assets in stocks.
Thermostat does not win every year. As stocks climbed in in 2006 and 2007, the fund switched to fixed income. For a time, the fund trailed badly. Then in 2008, the bond stake enabled the portfolio to sail through the financial crisis with relatively little damage. Once markets sank, Thermostat began buying. The fund’s stock-heavy portfolio enjoyed big gains when the market started rocketing up in the spring of 2009.
Thermostat was launched in 2002 by Ralph Wanger, a veteran portfolio manager who ran Acorn Fund, which outdid the markets for more than two decades. During his long career, Wanger—who is now retired–observed that markets tended to move in cycles, rising for years and then suffering prolonged periods of poor returns. From 1962 through 1982, stocks moved sideways. Then starting in 1982, stocks recorded a huge rally that only ended when Internet companies collapsed in 2000. Studying financial history, Wanger figured that the market was due for a time of little gains. He created Thermostat for the poor conditions—and his dismal outlook proved to be on target.
The fund has excelled in the past decade because stocks have gone nowhere, rising periodically and then falling back. In that erratic environment, Thermostat bought stocks on dips and sold on gains—a formula for producing solid returns. But in a period of steadily rising markets, Thermostat would be left behind, holding cash while stocks climb. If you think that markets are due to rally for the next decade, should you stay away from Thermostat? Not necessarily. Because the fund excels in downturns, it can be a sound holding that can diversify a portfolio.
Another star during the financial crisis was Leuthold Asset Allocation, which has topped the S&P 500 by half a percentage point during the past five years. The fund can put up to 70% of assets in stocks when they appear cheap compared to bonds. When the market looks expensive, the portfolio can have as little as 30% in stocks. Heading into the financial crisis, the fund had 50% in stocks.
The portfolio currently has 65% of assets in stocks. “Right now valuations are not at the high end, and they are not screaming cheap,” says portfolio manager Matt Paschke.
Paschke says that the economy is slowly improving. Homebuilding is increasing, and mortgage interest rates remain at record lows. Other positive signs include increases in the number of jobs and record corporate profit margins. While stocks seem somewhat attractive, bonds hold little appeal because of their skimpy yields, Paschke says. These days he has 4% of assets in gold. That serves as an insurance policy, an asset that can hold its value when other investments collapse.