Small Differences In Funds Matter Over Long Term Income Will Cushion Fall, Hasten Upturn When Market Hits Soft Spot

Growth and income funds. Equity-income funds. Balanced funds. They seem at first glance to be the same, using stocks and income from bonds and stock dividends to grow.

There are differences, and they matter in a long bull market where the funds that carry a larger percentage of stocks do better than those reliant on more income. But that reverses in bear markets, where the income not only moderates declines but also helps the funds recover more quickly as the markets come back. And the bull market gain might be less than one thinks and, therefore, not as valuable as a bear-market cushion.

Basically, the difference between the growth and income funds, equity-income funds and balanced funds is the proportion of income to equity.

Balanced funds, which have the lowest return of the group in bull markets - 74.2 percent over the past five years - usually get about 40 percent of their return from bonds and dividends.

Equity-income funds, which may hold bonds but also seek high yields from dividends, had a five-year return of 98.3 percent. Growth and income funds, which usually seek some dividend income, but rely mainly on stock growth, returned 101.5 percent. Standard & Poor’s 500 index funds, which are considered growth and income funds, returned 110 percent over the same period, in part because they usually have much lower expense ratios than the managed funds.

It is not as if growth and income funds are undiscovered. If they are coupled with S&P index funds, the class has about $430 billion under management, which puts them ahead of basic growth funds, which have $396 billion, and which they outperformed in the period by 7 percentage points. And because they are considered relatively conservative compared with growth and aggressive growth funds, they are the largest single holding in most 401(k) accounts.

But equity-income and balanced funds seem to be less well known.

“They all start at about the same place, but it is the degree of income that changes things. And most equity-income funds have a value approach to investing,” said John Markese, president of the American Association of Individual Investors. That means they focus on buying stocks that are trading at a discount to their “fair value,” rather than having the earnings-growth orientation of growth and income funds.

“You have to look at the prospectus and the investment approach of the fund to find out how it works,” he said.

“There are distinctions between the two (growth and income and equity-income),” said Brian Rogers, who manages T. Rowe Price’s equity-income fund, “but sometimes those differences are splitting hairs. There are equity-income funds that are a little growth and some growth and income funds that are managed like value funds. You really have to see how these are managed.”

That’s because some fund families have a variety of balanced, equity-income and growth and income funds, all of which take a different approach to investing, even though they may be called the same thing.

“There is more than one way to skin a cat,” said Vanguard group principal Brian Mattes. That company’s fund list includes six different growth and income funds, some of which rely on growth, others on value.

The investment approaches vary, even in value-oriented funds, which look for companies that seem to have something wrong, are overlooked or in a sector like retailing that hasn’t done well generally but has some companies that can do better, said Tom Reilly, managing director of the value equity group of Putnam Investments.

Reilly said he looks for dividend yields equal to, or higher than, the yield on the S&P 500. The S&P yields - calculated by dividing dividends by the share price - have fallen to less than 2 percent by S&P standards, mainly because prices have risen so much that a dividend that is steady in dollar terms becomes a smaller and smaller percentage of the share price.

Reilly’s most conservative fund, Balanced Retirement, has more than 50 percent of its assets in bonds all the time. The George Putnam Fund, also a balanced fund, usually has 30 percent to 40 percent of its money in bonds. But the equity-income fund drops bond holdings to 10 percent to 20 percent, and the growth and income fund only keeps up to 10 percent in bonds. The ranges allow some flexibility to deal with market conditions.

“We are looking for growth but with only about 80 percent of the volatility of the market,” Reilly said. “We control risk in the fund by varying the amount of exposure to fixed income.

“Bear in mind,” he said, that “it was much easier to recover from the crash of 1987 or the invasion of Kuwait because of the bonds in the portfolios.”

The income matters most in down markets, where it acts as an outrigger, stabilizing the funds’ performance. The more steady income, the more stable the return even as markets fall.

The less the fund falls, the shorter the recovery period. A fund whose share price drops from $20 to $10 has lost 50 percent of its value. But for it to get back to $20 it has to double in value, going up 100 percent.

Steady incomes can buffer a fall. A fund whose shares have dropped 10 percent but has a bond income of 6 percent, can, depending on the ratio of stock to cash, recover faster than a fund that has dropped the same amount but only has 2 percent income, because the total return has declined less.