Vanguard Convertible Securities, which just reopened to new investors, has beaten the stock market over the past ten years with far less risk -- and pays an attractive yield. By Steven Goldberg, Contributing Columnist June 7, 2010 Many investors avoid convertible securities because they’re complex. What’s more, they sound less like an investment than something to drive with the top down in nice weather. Big mistake. All you need to know to invest in a convertible fund appears below (almost all individual investors should avoid investing directly in convertibles because they are complex.) And Vanguard Convertible Securities (symbol VCVSX), which just reopened to new investors, is the pick of the litter. About the only negative: a $10,000 initial minimum. Look at the numbers. Over the past 20 years through June 4, the fund returned an annualized 8.7% -- an average of one percentage point per year ahead of Standard & Poor’s 500-stock index. The fund bested the S&P 500 by 19 percentage points during the 2000-2002 bear market and by 21 percentage points during the 2007-2009 cataclysm. It’s about 15% less volatile than the S&P 500, and it currently yields 4.84%. The Vanguard fund lost 29.8% in 2008, but it rebounded 40.8% last year. So far this year, it has gained 0.4%. The fund’s annual expense ratio of 0.72% is about half that of the average convertible-bond fund. You don’t need to be a risk-averse investor to like convertibles. You can count them as part of either your stock or bond holdings. Better yet, count convertibles as a little of both. Howard Marks, chairman of the firm that runs the Vanguard fund, calls them “equities with training wheels.” Advertisement If, like me, you think the stock market will continue to encounter turbulence, you should have no qualms about adding this fund to your portfolio. Or, as manager Larry Keele puts it, “Convertibles make sense if you don’t know what the future holds, and I don’t know what the future holds.” Convertible securities are hybrids -- part stock and part bond. Like bonds, they pay regular yields and can be held until maturity or until they’re called (redeemed) by the issuing company. But they can be converted to stock in the issuer any time at a preset price. So, for example, you might be able to convert one of these bonds, with a face value of $1,000, into 50 shares of stock. If the stock currently trades below $20, that’s a lousy deal. If it trades much above $20, it’s a good deal. Keele invests conservatively. He avoids so-called busted converts -- those that trade far below their conversion price, and thus essentially behave like bonds. And Keele sells converts when the price of the stock rises to the level at which it makes sense to convert the bond into shares. Yields on such converts are almost always very low because their prices have risen along with the stock price. Oaktree Capital, a respected money-management firm based in Los Angeles, has run the Vanguard fund since its inception in 1986. Keele, 53, has been investing in converts since 1983. He took over the fund in 1996. Advertisement The overwhelming majority of companies that issue converts carry below-investment-grade ratings. That means there’s a real danger they could default. But the Vanguard fund has never owned a convert whose issuer defaulted. Keele has five full-time analysts who study the creditworthiness of each convert. “We are a big credit shop,” he says. “We do our homework.” The convertible market is relatively small -- with only about $240 billion in the U.S. and a similar amount abroad. (The Vanguard fund has just 7% in foreign converts, all denominated in dollars.) Highly leveraged hedge funds employing esoteric arbitrage strategies pummeled the convertible market in 2008. Keele says many smaller hedge funds have disappeared, and the ones left are using less leverage (borrowed money). That should mean less volatility. Converts currently look attractive, Keele says. Companies hadn’t been issuing as many converts as usual because yields even on junk bonds were historically low relative to Treasury bonds. But yields on low-grade bonds of all sorts have climbed recently because of the European financial crisis. “Europeans have been panicking and selling everything they can,” says Keele. Some Vanguard shareholders also started selling, which is why the fund reopened after being closed to new investors for about a year. The fund holds $1.6 billion in assets. All told, Oaktree manages $4.6 billion in this convertible strategy. I wouldn’t overdo converts, but I think they make a nice 5% to 10% holding in almost everyone’s portfolio. They’re likely to continue doing what they’ve been doing -- offering good returns with relatively low risk. Steven T. Goldberg (bio) is an investment adviser.