'Extreme' Diversification Pays Off for Funds


When Michael Cuggino started managing Permanent Portfolio in the 1990s, some journalists thought the fund seemed like an odd grab bag. Cuggino holds a broad collection of assets, including gold, Swiss francs, Treasuries, growth stocks and real estate investment trusts.

During his early years at the helm, Permanent Portfolio lagged competitors who loaded up with soaring technology stocks. But Cuggino's fund has proved ideally suited for the harsh markets of recent times. For the decade ending in August, Permanent Portfolio returned 10% annually, more than 5 percentage points ahead of the S&P 500, according to Morningstar. While the S&P dropped 11.4% in the first eight months of 2008, Cuggino's fund gained 1.8%.

"We are designed for conservative investors who want to preserve their assets and achieve some growth," says Cuggino.

Academic researchers have long urged investors to spread their bets. Broad diversification can help to limit losses in downturns, the researchers have argued. Cuggino follows the academic advice -- and takes it to an extreme. His fund is one of a small number of extreme diversifiers that go well beyond holding a narrow collection of stocks or bonds. As the academics have promised, the broad funds have proved resilient in the market downturn.

Much of Permanent Portfolio's success can be attributed to its careful selection of assets that complement one another. For example, the fund's gold holdings sometimes rise when stocks are falling. Swiss francs may climb when Treasuries dip. During the fund's history, each asset in the portfolio has suffered more than one bear market. But there has never been a time when all the assets have dropped at once. That explains why the fund has not recorded a losing year since 1994.

To maintain diversification, Cuggino always has positions in each of his asset classes. He varies the mix only slightly. The fund keeps between 18% and 22% of assets in gold. The allocation for growth stocks ranges from 13% to 17%.

Another broad fund is Evergreen Asset Allocation, which is run by Ben Inker, who is asset-allocation manager of the noted value manager GMO. Inker invests in GMO funds, picking from among 15 choices. The Evergreen fund typically has holdings in an eclectic mix that includes emerging-market stocks, foreign currencies, high-quality bonds and funds that sell stocks short. Currently Inker is taking a defensive position, with 45% of assets in equities, down from the fund's neutral position of 65%.

Worried that the market slump will continue, Inker has shifted away from shakier assets, including small stocks. He is emphasizing blue chips, such as Johnson & Johnson and Microsoft. "With the best blue chips, the risk of bankruptcy is low, and profitability holds up in downturns," says Inker.

Investors in Evergreen can take comfort from GMO's long record of making spot-on market calls. In 2002, GMO Chairman Jeremy Grantham told shareholders to expect years of negligible returns in stock markets. He suggested emphasizing real estate investment trusts and inflation-protected bonds. Then in April 2007, a month when the S&P 500 was rising, Grantham warned that markets around the world were plagued by bubbles that would soon pop. So far, the forecasts have proved painfully accurate.

Like Evergreen Asset Allocation, PIMCO All Asset invests around the globe. Portfolio manager Rob Arnott owns a range of PIMCO funds, including portfolios that specialize in commodities, real estate and blue-chip stocks.

At the moment, Arnott is underweighting stocks and emphasizing inflation-indexed securities. He figures the consumer price index, which is currently rising at a 5.4% annual rate, is misleading. For the typical consumer, real inflation is more than 8%, he says. That steep rate will help to make inflation-indexed securities more valuable.

PIMCO has a particularly big stake in emerging market bonds. Arnott says bonds from countries in Latin American and Asia pay relatively high yields and come with reasonable risk. At a time when the U.S. Treasury is straining to borrow, emerging economies are in relatively healthy shape. "While we have massive current account deficits, many of these countries have surpluses," says Arnott.

During the past year, the PIMCO fund has returned 4.7%, about 15 percentage points ahead of the S&P 500. That strong showing demonstrates how extreme diversification can protect portfolios in harsh times.

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