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Whenever stocks fall sharply, as they did this summer, active fund managers sense an opening. Traditional stock pickers begin to argue that they can outperform because they've got the flexibility to avoid land mines, unlike index funds, which must hold all the securities in their market.
Alas, active management is no guaranteed salve. In terrible 2008, roughly half of actively managed large-cap stock funds beat their benchmarks. Still, this doesn't mean you shouldn't seek out fund managers who can outperform in tough times. "By losing less in down markets, a fund needs less time to rebound" when stocks recover, notes James Underwood, chief portfolio strategist at Welch Hornsby Investment Advisors. A portfolio that fell 20% less than the S&P 500 in down months needed to generate just 86% of the market's gains in up months to match the index's long-term return, Underwood calculates. And it would have been about 17% less volatile.
The question is, How can you find such stalwart funds and incorporate them in your plan?
Where to Look
While past performance is no guarantee, "funds with a history of outperforming when stocks fall will likely lose less in future downturns," says Russel Kinnel, director of fund research at Morningstar.
Focus on funds with solid "downside capture" ratios over the past 10 years. This ratio, which you can look up under a fund's "ratings and risk" at Morningstar.com, gauges a fund's performance relative to the market in down months. Make sure the current manager is responsible for that entire record so you can be certain you're dealing with someone who cares about downside protection. With this ratio, below 100 is good—and the lower, the better.
For instance, AMG Yacktman Focused (YAFFX) has a downside capture of 78 over the past 10 years. This means the fund lost 22% less than the market in down months. Yet over that decade, the fund beat the S&P 500 by more than two percentage points annually. Tweedy Browne Global Value (TBGVX) sports a downside capture of less than 55 over the past decade, compared with an international stock index. That has helped it beat 99% of similar funds.
How These Funds Do It
The managers at Yacktman and Tweedy Browne tend to hold cash when they think stock valuations are too high. That "cash drag" can slow returns during bull markets but often proves helpful when the market begins to fall. Then the money can be used to snap up bargains as valuations become more compelling. AMG Yacktman Focused, for example, had a cash stake of more than 30% coming into the 2008 bear market. It fell less than 24% that year, compared with 37% for the S&P 500. When stocks rebounded in 2009, the fund, which had gone on a buying spree, gained a brisk 63%.
Other funds, such as American Century Equity Income (TWEIX), lose less by emphasizing value-oriented stocks that typically hold up better in down markets. Invesco Dividend Income (FSTUX) and Vanguard Dividend Growth (VDIGX) specialize in reliable, quality companies with growing dividends, which investors tend to favor in rough times.
Why You Must Be Patient
Now, you'll have to accept one fact. "You're likely not going to have great performance in up markets, and your performance is not going to track a benchmark," notes Graham Pierce, a managing director at Beacon Pointe Advisors.
So before committing to such a fund, make sure you can sit through long bouts of relatively weak performance. During the three bull years of 2012 through 2014, for example, Yacktman lagged both the S&P 500 and most similar funds, according to Morningstar.
When You Should Really Care
Welch Hornsby's Underwood notes that funds with smaller average losses are ideal for money that will be tapped in 10 to 15 years. So they may be attractive for those in or near retirement.
"Your time horizon is vitally important when you are taking withdrawals," he says, as retirees have less time to recover from setbacks. As a guideline, funds that lose less should make up about 25% of a retiree's portfolio, he says.
That should be enough to help you sleep and retire comfortably.