Focus On: Convertibles

June 1, 2005

(Published 06/01/05) You can tell a lot about what’s hot and what’s not in mutual funds by just watching Vanguard.

Investors got gold fever? Vanguard closed their precious metals fund. Bond investors have no more Enron and WorldCom type fears? Vanguard closes their high yield bond fund. ETFs all the rage? Vanguard launches VIPERs. Nobody wants anything to do with utilities stocks? Vanguard re-badges their utilities fund as a plain-vanilla dividend growth fund.

We watch Vanguard closely, not just because several of their funds are in our model portfolios and on our favorites lists, but because Vanguard offers a strong signal of what smart investors should avoid or invest in.

Lack of investor interest is a good thing. Two of the hottest areas in the market over the last few years have been utilities and natural resources. Vanguard couldn’t give away their utility fund, so they gave it a strategy-altering makeover. American Century couldn’t find buyers for their global natural resource fund (an old holding in our newsletter) so they liquidated it. Both would have been up around 60% or more had they stuck by those funds as out-of-favor categories came back.

In 2003 plain old convertible bonds were on fire. Vanguard Convertible Securities (VCVSX) was up 31%. By 2004, investors were piling into Vanguard’s Convertible bond fund. In May when the fund neared a billion in assets, Vanguard simply had to shut the door. We dropped the fund as a favorite soon after, in August 2004.

From April 2002 until the end of September 2004 we had the convertible category rated 2 – Interesting. We had a convertible bond fund in our two safest model portfolios for much of this period. At the end of September 2004 we skipped 3 – Neutral and downgraded the convertible fund category to a 4 – Weak. (Too much of a good thing.)

Then a funny thing happened – convertible funds started to stink. Vanguard Convertible Securities was down 5.12% for the year to date as of May 31st, although it has recovered a bit recently.
Another funny thing happened: a half billion (about 50% of total assets) vanished from Vanguard Convertible Securities in a matter of months. In March of this year, Vanguard even opened the fund to existing investors while assets under management continued to drop (previously the fund was hard-closed, meaning essentially nobody could buy). Still, the assets fell.

On June 23rd Vanguard announced the fund was now open to new investors once again, but with a couple caveats: 1) the minimum is raised from $3,000 to $10,000, and 2) the fund will slap a 1% redemption fee anybody (who buys after September 15th 2005) selling within a year.

So now that the performance chasing investors have left the convertible bond market, we can safely upgrade the category to 3 – Neutral. We can also add Vanguard Convertible Securities back to our favorites list, it will join our other favorite pick and former portfolio-holding Northern Income Equity (NOIEX). Unlike Vanguard’s previously bloated fund, this fund has done fine over the last year, up about 11% landing it in the 10% of similar funds, although the fund underperformed when convertibles were red hot in 2003.

Category Rating: (Neutral) - Should match the markets return and perform in the middle of other stock fund categories

Previous Rating (12/31/05): (Weak) – should underperform the market and 60% of stock fund categories

Expected 12-month return: 5%

1. Northern Income Equity Fund (NOIEX) 9/01 32.82% 12.75% -1.43% 8.89%
2. Vanguard Convertible Sec (VCVSX) 5/05 0.00% 0.00% 0.00% 1.19%