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The Smart Money, Foiled Again

So far, the financial crisis on Wall Street has been as unpredictable as it’s been severe. Consider some of the twists and turns we’ve already witnessed:

A series of storied, blue-chip banks and brokerage firms with long track records of earnings growth suddenly collapse.

The Dow plummets 777 points in a single day after one Wall Street bailout plan fails in the House of Representatives. And the Dow falls an additional 157 points on the day a second plan becomes law.

Panicked investors renounce risk-taking, pushing the financial sector down by more than 20 percent since June. Yet there is enough of a gambling streak left to send shares of the perceived winners of this shake-up soaring, like Bank of America , up 54 percent; Wells Fargo , up 45 percent over the past three months; and JPMorgan Chase , up 30 percent.

It is hard to make sense of this market, which is precisely why you shouldn’t assume that conventional wisdom is correct about how to play the crisis.

The so-called smart money seems to avoiding three big investment categories: index funds, dividend-paying companies and small-caps. On paper, that seems to make perfect sense in these times. If you do a little homework, however, you will notice that some of these ideas haven’t panned out. At least not yet.

TO INDEX OR NOT

There is a simple reason for making the case that investing in index funds won’t work in this crisis: Financial stocks represent one of the two biggest sectors in the Standard & Poor’s 500-stock index, currently accounting for 16 percent of it.

Actively managed funds would seem to have an advantage, since their managers have the freedom to step out of this losing sector and redeploy that money.

That is the theory. In reality, most actively managed funds didn’t have the foresight to avoid the meltdown in the financial sector. At the start of September, for example — before the government’s takeover of Fannie Mae and Freddie Mac and its bailout of the American International Group — the average actively managed large-cap fund invested nearly 15 percent of its assets in financial services. That was almost exactly the sector’s weighting in the S.& P. 500 at the time.

That may explain why active managers haven’t been able to outperform basic index portfolios lately. Morningstar, the mutual fund tracker, did the calculations and found that the average large-cap index fund fell 26.8 percent over the past year through Sept. 29. That is almost the same as the 26.7 percent decline for actively managed large-cap funds. Over the past three years, their results were exactly the same: both active and index funds posted annualized losses of 2.2 percent.

Among small-cap portfolios, index funds actually beat the average actively managed fund over the past year, three years and five years — even though small-cap index funds maintain a far greater weighting in financial stocks than their actively managed counterparts.

THEDIVIDEND QUESTION

Financial stocks account for roughly a quarter of all the dividends paid out by the S.& P. 500 index, leading many people to say that investing in dividend-paying stocks isn’t advisable now.

As banks, brokers and insurers have run into hard times, many firms have cut or eliminated their dividends. This year, 30 financial companies in the S.& P. 500 have cut their payouts to the tune of $24.1 billion, according to Standard & Poor’s.

For Investors

This certainly shows the dangers of betting on a handful of individual dividend-paying stocks. “If you’re trying to get income by owning just three or four high-yielders, you’re taking a big risk that one or more will run into trouble,” says Luciano Siracusano, director of research at WisdomTree asset management.

But Mr. Siracusano noted that this doesn’t mean that diversified dividend investing strategies will fail in this market.

In fact, they are working. Not only did dividend-paying stocks in the S.& P. 500 beat non-dividend-payers in September — the height of the financial crisis — the dividend-payers have also outperformed over the past yearlong bear market. In the 12 months through September, around the market’s peak, dividend-paying stocks have fallen 22.1 percent, versus a drop of 27.5 percent for nonpaying shares, according to Howard Silverblatt, S.& P.’s senior index analyst.

Some funds focus on dividend-paying stocks that have consistently raised their payouts, and these funds are performing particularly well. Consider the SPDR S.& P. Dividend E.T.F., an exchange-traded fund that tracks the S.& P. High Yield Dividend Aristocrats index. It includes only high-yielding stocks that have managed to raise dividends for 25 consecutive years, and it is down just 6.8 percent since the start of the year. Compare that with the 25.1 percent year-to-date loss for the S.& P. 500.

LARGE VS. SMALL STOCKS

Many economists and market watchers believe the financial crisis will push the economy into a recession, if it’s not already in one. “I can’t think of anyone who thinks there’s not going to be a recession now,” said Michael P. Balkin, co-manager of the William Blair Small Cap Growth fund.

If that is the case, the market could be in for a sustained period of volatility, which naturally drives investors to the safety of large, industry-leading companies. This may turn out to be the safest strategy. But here’s a surprising twist: Since the middle of March, small-company stocks are holding their own. Since March 10, the Russell 2000 index of small stocks is down 3.7 percent.

To be sure, small-cap stocks were punished in September, when the financial crisis really started to frighten the markets. But even then, small stocks lost 8 percent in the month, versus a drop of 9.5 percent for their large-cap cousins.

Earlier this year, the small caps’ superior performance was regarded as a sign that this economic downturn might be short-lived. Today, few people think that the economy is on the verge of accelerating. But the real reason for this performance could be simpler than that: small-stock earnings have just held up better in this crisis.

Steven G. DeSanctis, small-cap strategist at Merrill Lynch, noted in a recent report that small-cap earnings were expected to climb nearly 2 percent in the third quarter, versus an expected decline of 5 percent for the S.& P. 500. If this happens, it would be the fifth consecutive quarter when small-company earnings have held up better than those of large firms.

Nevertheless, in the short term, small-cap stocks may not perform as well as they have recently, Mr. Balkin warned. “They could just mark time, ” he said, especially if economic concerns come to the fore. But if the recession ends sometime in the first half, he said, 2009 could turn out to be a decent year for small stocks.

Paul J. Lim is a senior editor at Money magazine. E-mail: fund@nytimes.com.


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