Time to Put a Premium on Safety

With what he sees as many risks in the market, S&P's Philip Edwards reiterates some basic advice: Focus on quality mutual funds

Investors need "to be patient, to be diversified, and to focus on funds that invest in quality stocks." So advises Philip Edwards, managing director of Standard & Poor's Investor Services, which tracks and rates mutual funds. And he reports that in the second quarter of 2005, the average equity fund gained 2.4%, vs. 1.2% for the S&P 500-stock index.

Over the longer term, Edwards says, S&P has found that investors have an equal chance of winning with a large-cap index or large-cap fund. But the S&P SmallCap 600 and MidCap400 indexes often do better than funds in those sectors, he adds.

However, fund investors currently would do better by diversifying across the capitalization range with equity funds and among bond funds by sticking to short- and intermediate-term durations, Edwards says. Focusing on quality is the key now, in his view, because the market is full of risks, even though S&P sees the possibility of 3% to 4% market gains for the remainder of 2005.

These were among the points Edwards made in an investing chat presented July 5 by BusinessWeek Online and Standard & Poor's on America Online, in response to questions from the audience and from BW Online's Jack Dierdorff. Following are edited excerpts (AOL subscribers can find a complete transcript at aol.businessweek.com/chat):

Q: Before we delve into funds, Phil, what's the macro view at S&P on the tone and direction of the market?
A: We remain mildly optimistic. We think the market has the opportunity for 3% to 4% gains for the rest of the year. But we think there are a lot of risks in the market. And as a result, we think investors should remain diversified and focus on quality stocks.

Q: Have equity funds been pretty much tracking the market?
A: Actually, they've been doing slightly better than the market. They performed pretty well in the second quarter of 2005, with the average equity portfolio gaining 2.4%, vs. 1.2% for the S&P 500.

Q: Bond funds vs. stock funds?
A: I would say it's important to be diversified, and I would have some of both in the portfolio. On the fixed-income side, I would look for shorter-duration funds -- in other words, more intermediate- or short-term funds. On the equity side, I would be looking toward those that focus on blue-chip stocks -- that is, stocks with proven earnings and dividends.

Q: Is it wiser to buy mutual funds by sector rather than size of cap?
A: Again, it's important to diversify by cap size as well as by growth and value styles. For equity funds, we believe investors should participate in the large-, mid-, and small-cap funds, as well as growth and value. The amount of participation in each is dependent on an individual's risk tolerance and investment objectives.

Q: I have S&P 500 fund Fidelity Growth & Income (FGRIX ), Vanguard Health Care (VGHAX ), a little in some Janus funds -- I would like to cover mid cap. Do you think Mairs & Power is a good choice?
A: The Mairs & Power Growth Fund (MPGFX ) is one that has a tendency to cover companies in the Midwest because that's where the managers are based. So if you don't mind the geographic concentration, this can be a good choice. It has a strong track record, a low expense ratio, extremely low turnover, and experienced managers.

Q: What's your opinion of the American Funds?
A: Excellent, with the exception of their small-cap funds. They have some of the best portfolio managers that we have run across in our years of research. We utilize those funds whenever we have the opportunity.

Q: Vanguard Energy (VGELX ), I think, requires $25,000 -- is there another good fund that doesn't require so much?
A: AIM has an energy fund (IENAX ) that appears to have a very good track record and only a $1,000 initial investment, but its expenses are high. Excelsior has an energy and natural-resources fund (UMESX ) that has only a $500 minimum and below-average expenses. It also has a strong track record. Fidelity also has an energy fund (FSENX ) that has a decent track record and very competitive expenses.

Q: Please give me your take on Putnam funds.
A: Well, Putnam obviously had a hard time of it. Assets continue to leave the fund family. And we continue to take a cautious approach toward their funds. Meaning if you're already in, there isn't a large reason to get out at this point. But if you're not in, there isn't a compelling reason to get in.

Q: What fund family would you like to get into if switching out of Putnam?
A: Well, I would look at American Funds, Dodge & Cox, T. Rowe Price, and Goldman Sachs. They all offer a wide array of very strong products.

Q: Your thoughts on Vanguard's Health Care fund (VGHAX )?
A: This fund has a very strong track record and a manager who has been in place since 2001. Typical of many Vanguard funds, its expense ratio is extremely low. However, we also show this fund as closed to new investors.

Q: How often should one fine-tune or tune up one's asset allocations?
A: That's a good question. I would say that at least annually you need to take a look at the asset allocation and the weights, and at a minimum rebalance. By rebalance, I mean taking profits and putting them into areas that have more opportunity for growth.

For example, real estate has done very well over the last two years, and I would consider taking some profits from there and putting them into a weaker area, such as large-cap growth. I also wouldn't look at it more than quarterly. I believe there's such a thing as overmanaging an asset allocation, as they're intended to be fairly strategic and long term.

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