If the turmoil gripping the Middle East—and the stock market—worsens, these savvy mutual funds should still hold up under fire. But diversification remains a smart strategy in any climate
Tension is high in the Middle East, and so are blood-pressure levels on Wall Street. Oil prices touched an all-time record of $78.40 on July 14 amid escalating violence in Israel and Lebanon, as major indexes ended the week with three straight days of heavy losses (see BusinessWeek.com, 7/14/06, "Stocks Slide as Global Worries Persist"). Geopolitical trouble-spots Iran, North Korea, and Iraq continue to simmer while fears of inflation or recession unsettle the home front.
While it's impossible to predict the outcome of current world events, for the moment let's assume a worst-case scenario. If increased military conflict leads to $100 barrels of oil and a broader U.S. economic slowdown, what should a worried investor do? Under those bearish circumstances, gains would be few and far between. But a "bunker portfolio" with a few smart mutual funds could at least contain the financial damage.
A bunker portfolio would include funds that might outperform the broader market when worst comes to worst. That means natural resources funds, along with balanced funds, long-short funds, and perhaps some low-cost bond funds, analysts say. However, others caution that a properly diversified grouping spanning a full array of asset classes might be the best bunker portfolio of all (see BusinessWeek.com, 7/11/2006, "Time to Put a Premium on Safety").
COMMODITY COVERAGE. If war is human nature, the sector most likely to gain from continued Mideast turmoil is probably natural resources. Shares of Exxon Mobil (XOM ) gained 3.3% in the week ended July 14, while Chevron (CVX ) advanced 4.2%, despite a 2.3% decline in the Standard— Poor's 500 index. "Energy funds would be a good hedge," says Lipper research analyst Jeff Tjornehoj.
One way to play the natural resources sector is to invest in funds tied directly to commodity prices. For example, PIMCO CommodityRealReturn (PCRAX ) posted a three-year average annualized return of 17.48% through June 30, vs. 13.55% for its mutual fund peers with the same investing style, though it carries a 1.24% expense ratio and a hefty 5.5% sales load. The fund invests in structured notes linked to commodities and tracks the Dow Jones-AIG Commodity index. New exchange-traded funds, or ETFs, such as Deutsche Bank's (DB ) DB Commodity Index Tracking Fund (DBC ), can also provide natural resources exposure.
Funds that invest directly in energy companies are a more straightforward option for investors looking to strike black gold. Vanguard Energy (VGENX ) is a low-cost choice, with an expense ratio of 0.28% compared to a 1.31% peer average. The fund has also turned in an appealing performance, averaging annualized returns of 25.08% in the five years ended June 30, vs. its peers' 19.6%. "It's also going to be a nice long-term holding," says Russel Kinnel, director of mutual fund research at Morningstar (MORN ).
IN CASE OF MARKET MELTDOWN. Balanced funds and long-short funds may provide additional security for investors who don't want to ride out a down market. "They'll have better down-market performance than indexes, but you'll lag the market on the upside," notes Robert Walsh, a Red Bank (N.J.)-based financial planner with the Alliance of Cambridge Advisers. Still, Walsh says investors may be better off sticking with a few low-cost index funds rather than trying to time the market.
Balanced funds may invest in both stocks and bonds, so managers can shift into fixed-income securities if they foresee a market meltdown. One balanced fund Walsh likes is Greenspring (GRSPX ). This fund's top holdings include semiconductor equipment maker Brooks Automation (BRKS ) and drugmaker Sepracor (SEPR ), while its five-year average annualized return of 8.85% handily tops 3.55% for its peers and 2.49% for the S&P 500. It carries a below-average expense ratio of 1.16%. However, the fund can be volatile, so investors should use it cautiously.
A less-volatile option is Dodge&Cox Balanced (DODBX), with an average annualized five-year return of 9.27% and a 0.53% expense ratio. The fund invests in mid-cap and large-cap stocks such as Hewlett-Packard (HPQ ) and Sony (SNE ), with an emphasis on value. U.S. Treasury bonds are also a top holding, and the portfolio management team boasts an average tenure of 15 years.
BEWARE THE BEAR. Another value-oriented balance fund, Oakmark Equity & Income (OAKBX), takes an all-cap approach and has benefited in recent years from the outperformance of small-cap stocks. With a 9.4% five-year average annualized return, the fund's biggest holdings are U.S. Treasuries, XTO Energy (XTO ), and EnCana (ECA ). It carries an expense ratio of 0.89%.
Elsewhere, funds that hedge against bear markets by taking short positions could bolster a bunker portfolio, though shareholders risk missing out on market rebounds. Hussman Strategic Growth (HSGFX ) uses put and call options on broad indexes, rather than shorting specific stocks. Its 11.55% five-year average annualized return compares to 2.3% for its peers over the same period, while its 1.24% price tag is just slightly above the category average.
Rydex Investment and ProFunds also manage a variety of funds that use shorting strategies. Meanwhile, ProFunds recently launched its ProShares series of ETFs, which include four funds that seek to match the inverse of a given index's returns (see BusinessWeek.com, 6/22/06, "Spread Your Bets in ETFs"). Four other ProShares ETFs use leverage to try to double those inverses. These funds have limited track records and a high level of risk, so they're probably not for the novice investor.
DIVERSITY IS THE BEST DEFENSE. In a global downturn, bond funds might be another good safe harbor for risk-averse investors. Vanguard Long-Term Treasuries (VUSTX) has a low expense ratio of 0.26% and invests mostly in long-term Treasuries. Its five-year average annualized return of 6.37% is slightly better than its peers' 5.98% and is close to that of its benchmark, the Lehman Brothers Long Government index, which returned 6.64%. Still, the fund is sensitive to the risk of continued Federal Reserve interest-rate hikes (see BusinessWeek.com, 7/11/06, "Don't Bet on a Bond Rally").
These defensive strategies may outperform in case of a global economic calamity, but financial advisers caution that a well-diversified portfolio is generally the best approach for long-term investment success. Diversification typically diminishes a portfolio's volatility. "When I think of a bunker portfolio I think of one that is really well diversified," says William Cuthbertson, principal at San Juan Capistrano (Calif.)-based financial planning firm Fiscalis Group.
It's important to remember that the best tool for reducing risk is time, notes Richard Bernstein, chief investment strategist at Merrill Lynch. "The probability of losing money in an investment generally decreases as the investment time horizon lengthens," Bernstein wrote in a July 17 report. "The probability of losing money is 46% when investing in the S&P 500 for one day, and that probability gradually decreases as time goes on."
A worst-case scenario hasn't arrived, and investors shouldn't bet on one, analysts say. Still, if oil does hit $100 a barrel and the economy sputters, a good bunker portfolio can protect your hard-earned money without the discomfort of sticking it under the mattress.