Time for Convertibles Again?

07/13/2010 1:00 pm EST

Focus: FUNDS

Daniel Wiener

Editor, The Independent Adviser for Vanguard Investors

Daniel Weiner, editor of the Independent Adviser for Vanguard Investors, says a Vanguard fund focusing on convertible securities has reopened for new investors.

Vanguard Convertible Securities (VCVSX) is open again. But will investors care?

The last time Vanguard shut the door on Convertible Securities was June 19, 2009. Within months, cash, which had been flooding into the fund and was the reason cited for the closure, turned around and started flooding out. Meanwhile, performance had already begun to lag.

Today, the fund is beginning to show better relative performance, and with the doors open again, it's almost a given that cash will begin flowing in once more.

Convertibles aren't well understood by most investors and so don't always attract the attention they deserve for providing good risk-adjusted returns in volatile markets. The securities [manager Larry] Keele focuses on have bond-like qualities but can also be converted into stock.

Called convertible bonds, they pay a substantial yield and are often issued by companies whose common shares pay no dividends. While convertibles tend to underperform their equity siblings when markets are rising—only going up about two-thirds as much, according to Merrill Lynch—they tend to fall a little over half as much when markets are dropping.

[So,] convertibles can be a conservative investment for equity-leaning investors and can also be used as an alternative or diversified addition to high-yield or "junk" bonds. Slowly rising interest rates, which is what I believe we'll see in the quarters ahead, should not have a huge impact here. They certainly didn't during the 2004 to 2006 period, when the Federal Reserve raised rates from 1.00% to 5.25%.

How long Vanguard can keep the fund open [this time] will almost certainly depend on how the market and the fund perform.

From the spring of 1999 into early 2000, the fund began to outperform Vanguard 500 Index (VFINX) substantially. Cash began pouring into the fund, [but] the flood was minor and short-lived, though the money continued in for months after the fund began to lag the market.

Vanguard shut the doors in May 2004. Performance against the index began to falter, and cash began to flood out. It wasn't until months after the June 2005 complete reopening of the fund to all comers that money began to flow back in, at just about the time that relative performance began to pick up.

A fairly steady but small flow of new money moved in over the next couple of years, but that flow picked up in November 2008 as stock markets faltered and the fund's relative outperformance really began to show.

By June 2009, when the fund was closed again, Convertible Securities had seen eight straight months of positive and rising cash inflows. The May 2010 reopening follows eight straight months of increasing outflows.

So, what to do?

I'm a fan of Larry Keele's fund and strategy, and believe its best use is in an income-focused portfolio where higher yields and lower risk are more important than absolute tax efficiency and performance. That's why I rate the fund Buy.

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