Finding Right Mix to Capitalize on Stock Rally

There’s nothing quite as frustrating as lagging the market during a rally. You invest in a stock mutual fund that’s supposed to be a solid performer then watch with dismay as it can’t even keep up with an unmanaged index like the Dow Jones industrial average or Standard & Poor’s 500.

Sound familiar? It should, because most stock funds fail to beat the market during rallies. And unlike bond and money market portfolios, whose returns tend to cluster together, equity funds generate performance that’s all across the board. During the current rally that commenced in mid-January, some funds have shot up more than 25%, while others have nudged up barely 3% or 4%.

What factors cause such discrepancies? Several come into play, but the key one is the extent to which a fund is invested in stocks versus other assets, notably cash.

Cash holdings--Treasury bills, bank deposits, short-term corporate debt and the like--provide great protection during downdrafts in the stock market. But when equities are rallying, a high cash position puts a lid on a fund’s return potential. “We tend to stay nearly fully invested in stocks at all times,� says Jeffrey Malet, manager of Pacific Horizon Aggressive Growth Fund, run by Pacific Century Advisers of La Jolla. That helps explain why his fund shot up better than 25% during the current rally.

Not all managers were so fortunate. The Mathers Fund, a highly regarded growth stock portfolio based in Bannockburn, Ill., has risen just 3% during the same period. Manager Henry Van der Eb seeks capital preservation above all else, and he’s had Mathers’ assets mostly in cash for more than a year.

In fact, stock fund managers in general were defensive leading up to the current rally. Average cash holdings hit a record 12.9% in October and remained at a lofty 11.4% in December, the most recent month for which numbers have been tabulated by the Investment Company Institute.

Of course, if you want to reduce volatility there’s nothing wrong with investing in a stock fund that can take a big cash position. Treanna Allbaugh, co-editor of the MPT Fund Review newsletter in San Francisco, recommends several growth portfolios whose managers move to the sidelines during periods they deem treacherous. Her choices include New York-based Gabelli Growth and Gabelli Asset Funds, Denver-based Janus and Janus Twenty Funds and the SteinRoe Special Fund of Chicago.

“One advantage of these types of funds is that their managers are moving in and out of stocks like market timers, according to their own models,� Allbaugh says. As such, there’s no need for investors to switch in and out of the funds.

Of course, the same buy-and-hold argument can also be made for more volatile growth funds, if you’re willing to hang on for several years. “Over time, growth stocks are one of the best-performing assets, better than just about everything else,� says Malet. “Though there will be short-term fluctuations . . . you should hold for the future.�

If you don’t trust a manager’s ability to time the market, you might gravitate toward funds that remain in stocks around the clock. For instance, the equity funds managed by Twentieth Century Investors of Kansas City, Mo., maintain close to a 100% equity weighting all the time. This same approach is shared by Fidelity Magellan. Notably, Magellan ranks as the top mutual fund of all during the past 15 years, while Twentieth Century has the No. 2 and No. 3 portfolios.

In the same vein, index funds stay fully invested, with the added twist that they hold the same stocks included in popular market averages, such as the S&P; 500. The advantage here is predictability: You know your fund will move in line with the index it tracks.

A handful of investment companies--including Colonial Funds of Boston, Rushmore Group of Bethesda, Md., and Vanguard Group of Valley Forge, Pa.--offer index funds linked to small-stock averages, foreign markets and the like. Allbaugh likes the Vanguard Index Trust 500 Portfolio, which tracks the S&P; 500.

Whether you buy volatile stock funds or defensive ones, it makes sense to invest regularly. Phillip E. Cook, a certified financial planner with Financial Network Investment Corp. in Torrance, suggests dollar cost averaging--a systematic approach in which you invest a fixed dollar amount at set intervals. “I usually recommend making monthly contributions, and I also like the idea of reinvesting your quarterly dividend checks.�

Cook likes two portfolios run by American Funds in Los Angeles: Washington Mutual Investors Fund and Investment Company of America. Both seek capital appreciation and dividend income. This makes them more conservative holdings, because high-yielding stocks tend to exhibit less volatility than pure growth issues.

In addition to cash weightings, equity funds also vary according to the types of stocks they own. Most sectors of the market have participated in the current rally, but the big winners have been smaller stocks. The NASDAQ Composite Index, a benchmark for over-the-counter equities, has risen twice as much as the S&P; 500 and the Dow industrials. The recent deviation is a potentially big one, since smaller issues have trailed large stocks most of the time since 1983.

Malet believes that the current small-company rally is for real. “It’s not too late to jump in. There’s plenty of potential left,� he says. Small stocks tend to either lag or lead the market for six or seven years at a stretch.

Cook suggests that conservative investors build their portfolios around fixed-income investments. But he adds that most people should have some equity holdings, including perhaps a 10% weighting in small-company funds. “Small companies are where the growth is,� he explains. “They’re the ones with the new techniques and the entrepreneurship. They should outperform long term.�

HOW HIGH IS TOO HIGH? Given the power of the current stock market rally, you might wonder whether prices have become overextended. David Vomund, a research analyst at Target Inc. in Pleasanton, Calif., follows a simple market-timing tool to spot optimum points to buy or sell equity funds.

Vomund charts the New York Stock Exchange Composite Index in relation to its 30-day moving average. He then shifts the moving average up by 6% and down by 4% to create a trading range orband. When the index drops to where it touches the lower end of this range, as happened in early January, he buys. When it rises to the upper end, he sells.

Recently, the index burst through the upper limit, suggesting stocks are overpriced, at least in the short term. However, the power of the upsurge points to a favorable long-term trend, he says. “I interpret this to mean we’re in a bull market.�

Vomund uses volatile equity funds to trade within his range. But he hastens to add that no timing system works perfectly. “The risk of being out of the market is greater than being in it,� he contends. Consequently, he recommends keeping some money at all times in steady stock funds such as Financial Industrial Income of Denver and Vanguard Wellington, part of the Vanguard Group in Valley Forge, Pa.