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MUTUAL FUNDS / CHARLES A. JAFFE

Check Conditions Before Riding in Convertible

February 18, 1996|CHARLES A. JAFFE | Charles A. Jaffe is mutual funds columnist at the Boston Globe. He can be reached by electronic mail at jaffe@globe.com. Russ Wiles' column does not appear this week

About a year ago, a national financial planners group called convertible securities "an investment vehicle for the undecided."

Since then, shrewd marketers have pitched convertible securities funds as "the best of both worlds," offering the bounce of the stock market without so much risk.

Heading out of the sure-shot bull market of 1995 and into more uncertain times, the ranks of "the undecided" looking for "the best of both worlds" have swelled. So have the number of convertible securities funds and the advisors pushing them.

"Let's face it, when investors are becoming disenchanted or nervous, the sure-fire way for a mutual fund company to retain those customers is to come out with a new product that looks viable," says James Stack of the Investech newsletter in Whitefish, Mont. "It doesn't matter whether convertibles are a great investment--they are a very salable product."

Convertible securities are hybrid investments, most often interest-paying bonds (but sometimes preferred stock) that can be swapped for shares of the issuing company's stock at a predetermined price.

The bond-like yield facet of a convertible protects against stock declines, and the ability to convert into stock offers shelter against falling bond prices. Convertible fund investors, therefore, hope to put the top down and enjoy the ride when the sun shines and cover up for protection when things get stormy.

Supporters suggest that convertible funds deliver about two-thirds of stock market returns with half of the downside risk, making them attractively conservative. In theory, a convertible fund would gain 6.6% for every 10% market rise, but fall just 5% during a 10% market correction.

Convertibles have never been particularly popular, for two reasons. First, they're complex. Wise consumers are members of the don't-buy-what-you-don't-understand school of thought. Second, convertibles are designed to lag the market, and most investors prefer to try beating it. But with the current sales push and the explosion in convertible funds--there are now about 40 choices, up 33% in the last 18 months--there is one other prime consideration: An investment capable of providing the best of both worlds can also deliver the worst.

Last year, for example, when the stock market was up 34%, the typical convertible fund--as measured by the Lipper Convertible Securities Fund Index--was up 21%, not quite two-thirds of the market's increase.

In 1994, however, stocks lost 1.5%, but the average convertible securities fund dropped more than twice that.

Oops.

That little anomaly occurred because 1994 was an awful year for bonds--the average bond fund lost more than 6%--and convertibles are part bond. It was an abnormal situation, but it makes the point that convertibles don't come with a guarantee.

In addition, there is the concern that increased investment will make good convertible securities hard to find. The convertible market is small, with a limited number of high-quality choices. Without investment-grade options, some managers turn to junk or buy new breeds of quasi-convertibles--derivatives--which can increase a fund's volatility and risk.

Before being sold a on convertible securities as a conservative investment, decide if the concept is appealing. Be aware that the convertibles market is thought to be less efficient than the broad stock market, which means that good managers need to be especially savvy. If you still think convertibles have a place in your portfolio, be particularly careful in reading the prospectus.

Convertibles come in the same flavors as other funds--concentrating in certain sectors, in large or small companies and with a bias toward acting like a stock or a bond.

"Convertibles could fit into a lot of portfolios, especially for baby boomers saving for retirement," says Andrew Davis, who manages the Santa Fe, N.M.-based Davis Convertible Securities Fund. "But be sure you know the kind of convertibles you are buying, whether the fund is a bond substitute, equity-oriented or a hybrid. The easiest way to be disappointed is to like the idea of convertibles without really knowing what a fund buys."

Adds Ken Gregory, editor of the San Francisco-based No-Load Fund Analyst newsletter: "Investors should be suspicious any time something is pitched as a free lunch--an easy way to get high returns at low risk. Buy convertibles if they fit your strategy, not because they sound good in a sales pitch."

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