SAN FRANCISCO - Bond manager McKee Investment Management Co. Inc. uses unsexy utility stocks to spice up the performance of its core-enhanced portfolios.
In the fourth quarter, the San Francisco-based manager's core-enhanced strategy returned 5.6% vs. 4.2% on the Salomon Smith Barney Broad Investment Grade bond index, a hefty premium for fixed income. In 2000, the enhanced strategy returned 16.1%, more than 410 basis points above the benchmark, a staggering figure in the bond world, where victory usually is won in a cloud of dust rather than in Hail Mary touchdown passes.
In fact, since the enhanced strategy started 18 years ago, it has returned an annualized 12.2% vs. 9.7% for the SSB BIG index. President Barry Julien explained the firm invests 5% to 15% of core-enhanced portfolios in utility stocks, which he says have similar characteristics to bonds.
Professionals at McKee, which runs $530 million in the strategy, think utility stocks are a better fit for the enhanced portfolios than the emerging market debt or junk bonds many core-plus managers use. Those managers have taken on a lot of currency or credit risk, while McKee has retained an average AAA credit rating for its portfolios, he noted.
McKee eschews the growth-oriented stocks of most power producers, instead picking traditional distribution and transmission company stocks that kick off steady dividends, such as TXU Corp., GPU Inc. and NiSource Inc.
Those boring old stocks largely were ignored while technology stocks had their run, but money shifted to the sector after many Nasdaq stocks started imploding on March 10, 2000. "People started looking for cover to hide," said Mr. Julien, who boosted exposure to utility stocks to 10% to 11% from 6% to 7% last March. Then, energy prices started rising in the face of increased demand for power. "People started looking at the story and not just for a place to hide."
Fortunately, McKee managers knew when to get out as well, reducing holdings in the fourth quarter to about 7% at year-end. Included in that selloff was nearly all of the manager's stake in now-battered California utility Edison International; McKee earned a tidy profit on the sale.
The Federal Reserve's 50 basis-point rate cut further hit utility stocks, as managers switched back to growth stocks. "If things sell off considerably more, we'll probably ramp back to about 10%," Mr. Julien said.
From the sound of it, McKee clients are happy with the approach. "We have been clients for over 13 years. We've had exceptional long-term investment results," said Mary Ann St. Peter, chairwoman of the investment committee of the California Pacific Medical Center, San Francisco. McKee manages $40 million of the medical center's $225 million-plus in foundation and special-purpose assets.
Using utility stocks "helped in falling interest-rate environments through capital appreciation," she said. "In a rising interest-rate environment, the dividend growth of utilities has been able to minimize any potential losses one experiences."
But some consultants were leery about using any kind of equities in a bond portfolio. Explained Stephen Nesbitt, senior managing director at Wilshire Associates, Santa Monica, Calif.: "Most of our clients are going to be a little bit nervous (about using utility stocks) as an bond substitute. Because, from an asset allocation point of view, it's really a mismatch and the tracking error would be quite significant. It's really an out-of-the-box-type approach."
