Skeptical of Stocks? Try Convertibles

More than four years into a powerful bull market, there are signs that rank-and-file investors are creeping back into stocks. But they're doing so with fear, uncertainty and doubt, driven mainly by the lack of appealing alternatives. If you're skeptical of stocks and annoyed with the microscopic yields on bonds, consider convertibles — hybrids that give you a piece of both asset classes. Converts are part common stock and part bond or preferred stock (a security that behaves much like a bond). They offer you the chance to participate in stock market gains but with less risk than stocks. They also throw off more income than common stocks, though they typically pay less than a company's regular bonds.

One of the stars in this group is AllianzGI Convertible (symbol ANZDX). Although the no-load, low-minimum Class D shares of the fund have been available for only three years, the fund's institutional class is tops in the category over the past ten years, with an annualized return of 10.9% through May 17. That beat the typical convertible fund by an average of 3.7 percentage points per year. Moreover, the fund has been in the top 30% of its category in eight of the past ten calendar years.

The $1.5 billion fund normally keeps about 90% of its assets in converts. The rest is in traditional high-yield bonds, cash and converted stocks. The stocks don't stay in the portfolio for long. Once a bond or preferred share converts into a stock, it can stay in the portfolio for up to 90 days, says Justin Kass, who runs the fund with Douglas Forsyth. After that, the managers must replace each stock with a new convertible.

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Operating much like stock pickers, Kass and Forsyth look for companies that they think can beat analysts' revenue and earnings forecasts. They like firms that are leaders in their industries and can outperform their peers regardless of the vagaries of the broader stock market. Two big holdings, Gilead Sciences and Bank of America convertibles, helped propel returns over the past year. Other key players were bonds in homebuilder Ryland, data-center operator Equinix and media giant Time Warner. Converts from rental-car companies Avis and Hertz, which have both raised earnings expectations for the rest of the year, also contributed to the fund's performance.

Once the managers buy a convertible, they tend to hold it unless the company stumbles in some way. If a firm stops gaining market share or its operating margin (operating income divided by revenue) starts to shrink, the managers will consider selling. "If a new product missed or there is slowing demand in an area," says Kass, "we're going to move on." They don't set price targets on the underlying stock as triggers to sell. "We like to let our winners run," he says.

Allianz Convertible has a turnover ratio of 108%, suggesting that each holding stays in the fund for an average of less than one year. The no-load Class D shares have an expense ratio of 1.06%. Allianz runs this fund independently from its subsidiary, Pimco, the fund firm based in Newport Beach, Cal. Pimco manages its own convertible fund with a separate strategy.