An All-Weather Fund for the Ages

09/16/2009 10:42 am EST

Focus: FUNDS

Russel Kinnel

Editor, Morningstar FundInvestor

Russel Kinnel, Morningstar’s director of mutual fund research, and analyst Katie Rushkewicz find a fund that does well in bear markets and outperforms over time.

Veteran manager Charlie Dreifus has run Royce Special Equity fund (RYSEX) since its mid-1998 inception, but his experience in the fund industry spans much longer, including 30 years at Oppenheimer and Lazard Freres. His conservative, time-tested approach has been successful here and elsewhere, especially during market downturns.

Dreifus was named Morningstar’s Domestic-Stock Manager of the Year in 2008 for protecting capital better than most managers that year as well as during the prior bear market.

Dreifus does most of the research himself, scouring balance sheets and financial statements to find healthy cash generators that are trading cheaply on a relative and absolute basis. If Dreifus doesn’t see compelling choices, he will let the fund’s cash stake grow—it was nearly a fourth of the fund’s assets in May 2009.

But this fund hasn’t missed out on the recent rally. From March 9 through June 19, 2009, it gained 37%. True, this trailed the average small-value peer and the Russell 2000 index by ten percentage points, but it’s impressive given that the portfolio has more cash than nearly all its rivals.

The fund’s flexibility extends past Dreifus’ willingness to go to cash. He doesn’t let sector concerns drive the fund, preferring to invest where he sees the most value. That means the fund can look drastically different from its small-value peers.

For instance, the fund had no financials exposure as of June 30, 2009, even though that makes up a sizable chunk of the Russell 2000 index. Instead, Dreifus has favored industrial and consumer stocks.

The fund [also] has a bigger helping of micro-cap stocks than many of its peers, including a few companies with market [capitalizations] of less than $100 million. These names tend to be smaller positions, so that his trading won’t move the stock price.

Although the fund tends to lag its peers in market rallies, it typically outperforms during downturns. That was the case during the bear market of the early 2000s, and it happened again in 2008. The fund’s 20% loss for the year was painful, but it fared better than the average small-value fund (down 32%) and the broad market (down 37%).

More importantly, the fund’s stellar long-term record—it’s gained 7.9% annually since its mid-1998 inception—beats nearly all of its small-value rivals.

Would-be investors need to know that patience is required with Dreifus’s conservative approach. The fund’s relative performance has suffered during prolonged market rallies—it posted bottom-decile showings in 2003, 2004, and 2005. But Dreifus has proved that losing less in downturns pays off handsomely over the long haul. This fund has a 7% annualized return since its mid-1998 inception, more than twice the gain posted by the typical small-cap fund or the benchmark in that time.

The fund’s expense ratio has remained steady at 1.15% since inception, even as assets have grown. However, it still falls below the median for no-load small-cap funds.

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