When the Market Teeters and Totters, These Funds Provide Balance

As the great bull market has stumbled in recent weeks, attention has focused on how some investors have shifted a small portion of their mutual fund assets from stock funds to the terra firma of money market funds.

What has gone relatively unnoticed is another trend signaling individual investors’ caution--a trend that has been going on since the beginning of the year.

Rather than give up stocks cold turkey, many investors are choosing to wean themselves from market risk by exchanging pure-stock portfolios for less volatile “balanced” funds, which invest in a mix of stocks and bonds.

At Scudder Kemper Funds, more money has flowed into the firm’s balanced portfolios so far this year than in all of 1997. And spokeswoman Meg Pier said balanced-fund inflows now are “well ahead of 1994’s record pace”--the last disappointing year for domestic equities.

In July, as the stock market fell sharply, the pace of money flowing into balanced funds sold by Vanguard Group, the nation’s second-largest mutual fund company, surged. A net $365 million flowed into the company’s balanced funds last month, up 65% from June’s inflow, said spokesman Brian Mattes.

Some financial advisors say investors are doing precisely the right thing. “This is one hell of a smart move,” said Gerald Perritt, head of Perritt Capital Management in Chicago and editor of Mutual Fund Letter.

Running to money market funds for safety sounds logical, but those funds shouldn’t hold long-term savings, many pros say. Why not? “They don’t pay anything,” Perritt notes.

The typical money market fund now yields 5.16%, annualized, according to IBC’s Money Fund Report, a trade weekly based in Ashland, Mass.

After taxes and inflation, investors may wind up earning as little as 2% in real terms, said Perritt. “You’d have to work until you’re 97 to make enough to retire at that rate.”

The typical balanced fund, on the other hand, has delivered annualized returns of 12.7% over the last 15 years, according to Chicago fund tracker Morningstar Inc. That’s nearly as much as domestic equity funds’ 13.2% average annualized return over the same period.

Yet the typical balanced fund has been nearly half as volatile as the typical domestic stock fund over the last three years, as measured by standard deviation.

Standard deviation judges a fund’s volatility based on how far its returns stray, or deviate, from its average return over an extended period.

By mixing stocks with interest-paying bonds, and usually some money market securities, balanced funds allow investors to stay in the stock market while maintaining a buffer against a horrendous market decline.

In 1990--the last bear market year--the average balanced fund lost just 0.2%. The average stock fund, by contrast, fell 6.3%.

“Balanced funds make a lot of sense for investors who don’t have the money or the time to allocate their portfolios themselves,” said Larry Chin, senior editor of the No-Load Fund Analyst, a newsletter based in Orinda, Calif.

Balanced funds also provide an easy way to rebalance your portfolio if you’re over-weighted in equities not by design, but because of the market’s heady gains in recent years, financial planners say.

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To identify some high-performing balanced funds, we started with Morningstar’s database of 668 “domestic hybrid” funds.

That’s the firm’s umbrella term for balanced funds and those that act like balanced funds, even if they aren’t classified as such.

Performance obviously matters. So we eliminated all those portfolios that didn’t beat at least 75% of their peers over the past three- and five-year periods.

Next, we sought relative safety. We did this in three ways.

First, we screened out all balanced funds that Morningstar considers riskier than the category average.

Then we eliminated funds whose bond holdings were predominantly low grade--in other words, junk issues--or long-term.

Why cut out funds that primarily own long-term bonds (meaning bonds maturing in 10 years or longer)? The longer a bond’s term, the more at risk it is to market interest rate fluctuations. Yet these days, long-term bondholders aren’t compensated for taking that additional risk.

Consider: The yield on 30-year U.S. Treasury bonds now is 5.62%. That isn’t much more than what money market funds pay.

“It’s not worth investing in long bonds” relative to owning shorter-term bonds, says Ridgewood, N.J., financial planner Paul Westbrook.

Finally, we screened for low standard deviation. The standard deviation of the average domestic equity fund, expressed numerically, is 16.4 over the last three years. We eliminated all balanced funds with a standard deviation of 10 or higher.

This left us with 12 funds, but we pared the list down to 10 because two of the portfolios required initial investments of $25,000 or more.

Details on the 10 finalists:

* Gabelli Westwood Balanced (no-load; $1,000 minimum initial investment; phone: [800] 937-8966). Co-manager Susan Byrne relies on the same stock-picking methods for this $129-million portfolio that she uses for the respected Westwood Equity fund.

First, she looks for companies trading at a discount to their earnings growth rate. For instance, if a company’s earnings are projected to grow 25% a year for the next five years, she isn’t likely to buy the stock unless its price-to-earnings ratio is well below 25.

Byrne also likes companies that have slipped up recently but whose recovery has yet to be recognized by Wall Street.

True, Westwood Balanced has under-performed the average balanced fund so far this year. It’s gained just 4.2% year-to-date. That’s largely because the fund is over-weighted in energy stocks and real estate investment trusts--high-yielding asset classes that are traditionally “defensive” but which have slumped this year.

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Still, defense is key right now. Concerned over Asia’s economic woes, Byrne has about 60% of her fund in stocks (the fund is permitted to go as high as 70%) and the rest in bonds.

Her caution also extends to the bond side: She owns mostly high-grade government and corporate debt with low sensitivity to interest rate swings.

* Janus Balanced (no-load; $2,500 minimum initial investment; [800] 525-8983). Despite having less than half its assets in stocks, this $584-million fund has managed to beat more than 90% of its balanced peers over the past one, three and five years.

How? Manager Blaine Rollins follows a Janus tradition of seeking out companies with predictable earnings streams and growing cash flow. Recently, this has led him to asset management companies like Charles Schwab & Co. and cable stocks like Tele-Communications Inc., which AT&T; Corp. plans to acquire.

Rollins also will invest in these companies through their bond issues. In recent months, for instance, Rollins has increased his stake in telecom and cable convertible bonds, which can be converted into the issuing company’s stock. Convertibles now represent about 20% of the fund’s assets.

Notes Rollins: “On down days in the market, these convertibles don’t move down nearly as much. Yet they have great upside potential, and some are yielding as much as 7%.”

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High-yield bonds make up another 16% of Janus Balanced, and high-grade corporate bonds and U.S. Treasuries make up the rest of the portfolio.

Surprisingly, this mix has produced a fund that Morningstar considers to be 65% less risky than its peers. It also has produced a total year-to-date return of 15.2%--three times better than the typical domestic equity fund.

* Vanguard Wellington (no-load; $3,000 minimum initial investment; [800] 662-7447). Investors seeking a traditional, predictable balanced fund will like this mammoth $24.7-billion portfolio.

Co-managers Ernst von Metzsch and Paul Kaplan maintain an approximate 60%-40% split between stocks and bonds. For stocks, Von Metzsch and Kaplan stick with value-oriented large-cap U.S. equities. (These should be easier to find today, thanks to the recent market correction.) As for bonds, Vanguard Wellington stays with U.S. Treasuries, which by definition are high-grade.

Over the last 15 years, this simple combination has led to average annualized returns of 14.4%, beating the return of the typical domestic equity fund.

* UAM FPA Crescent (no-load; $2,500 minimum initial investment; [800] 638-7983). As conventional as Vanguard Wellington is, Steven Romick’s $269-million portfolio is not. For starters, Crescent’s 46.4% equity stake is mostly invested in small- and mid-cap stocks--unusual for a balanced fund.

To offset that volatility, Romick invests in some other unconventional assets.

For instance, he has been adding more convertible bonds to his portfolio--in particular so-called busted bonds, whose prices don’t move in tandem with their underlying stocks, but which pay a decent yield.

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Romick also will buy high-yield debt. And he has about a quarter of the fund’s assets in cash right now.

On paper, this odd combination of small stocks, convertibles and high-yield bonds would not appear to be among the safer balanced-fund approaches. Yet Morningstar considers Crescent to be a stunning 72% less risky than its peers.

Although so far this year its return is just 2.8%, the fund has earned 16.8% annually over the last five years--more than 4 percentage points above the balanced-fund average.

* Capital Income Builder (5.75% load; $1,000 minimum initial investment; [800] 421-4120). In addition to investing in short-term U.S. Treasuries, this $8.5-billion balanced fund dampens volatility by seeking out stocks of large U.S. companies that pay steady dividends.

Thanks to this combination, Capital Income Builder has beaten more than half its peers in each full calendar year dating back to its 1987 inception.

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At the same time, Morningstar considers this fund 58% less risky than its peers. The current asset mix: 65.2% stocks, 17.4% bonds and 16.8% cash.

The fund has earned 5.1% year-to-date and 14.8% a year over the last five years.

* Fidelity Puritan (no-load; $2,500 minimum initial investment; [800] 544-8888). Like Capital Income Builder, this $25.1-billion fund favors high-yielding blue-chip names for its equity holdings.

That’s why more than a quarter of Fidelity Puritan’s equity stake--which represents about 63% of the fund’s total assets--currently is in financial services stocks, which trade at relatively attractive valuations and pay decent dividends.

Over the last 15 years, the fund has delivered average annualized returns of 14.7%. And it has produced those results with one of the lowest expense ratios in its category.

* Invesco Total Return (no-load; $1,000 minimum initial investment; [800] 525-8085). This $2.8-billion fund begins with the premise that, other things being equal, it will invest 60% of its assets in stocks and the remaining 40% in bonds.

But the fund’s four-member management team is willing to change the mix, depending on its projections for future blue-chip stock returns and the yield on 30-year U.S. Treasury bonds.

Since 1994 or so the fund has over-weighted stocks slightly (stocks currently make up about two-thirds of the fund’s assets), leading to a five-year annualized return of 15.9%.

Conservative investors will appreciate the fund’s preference for U.S. Treasuries and mortgage bonds, its low expenses, and its rock-bottom 4% portfolio turnover rate. (Turnover refers to how frequently the fund replaces the holdings in its portfolio every year. The average U.S. equity fund has a turnover rate of nearly 90%.)

* Vanguard Star (no-load; $1,000 minimum initial investment; [800] 662-7447). This $8-billion balanced fund doesn’t invest directly in stocks and bonds. Rather, it invests in other Vanguard mutual funds that own stocks or bonds.

Currently, Star has a stake in eight Vanguard portfolios, including familiar names like Vanguard Windsor II and Primecap, both of which invest in large blue-chip U.S. stocks.

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Star’s bond exposure comes largely through Vanguard funds that invest in government or mortgage-backed debt.

Despite being a “fund of funds,” Star stays true to Vanguard’s philosophy of ultra-low expenses.

The current asset mix: 62.7% stocks, 25% bonds, 12.3% cash.

* Mairs & Power Balanced (no-load; $2,500 minimum initial investment; [651] 222-8478). This $34.5-million fund--which is sold in only 9 states (including California)--has finished in the top 25% of its peers over the past one, three, five, 10 and 15 years.

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Yet it has had virtually no turnover--meaning it buys stocks and holds onto them for a long period of time.

The fund is up 6% so far this year and 15.6% annually over the last five years.

* Flag Investors Value Builder A (4.5% load; $2,000 minimum initial investment; [800] 767-3524). Here’s another balanced fund that buys relatively safe stocks and seeks to hold them for years.

Thanks in part to that strategy, this $505-million fund, which has 56.9% of assets in stocks today, 29.2% in bonds and 9.3% in cash, has beaten 75% of its peers every year since 1994.

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Fund Strategies considers tactics used to choose mutual funds. Times staff writer Paul J. Lim can be reached at [email protected].

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Seeking Stability

Balanced funds’ growing popularity has made them the fourth-largest stock fund group. Assets, in billions:

Growth: $648

Growth & income: $593

Foreign/world: $374

Balanced: $153

Equity income: $151

Small cap: $149

S&P; 500: $137

Sector: $112

Note: Data as of June 30

Source: Lipper Analytical Services

The Right Balance: 10 Fund Ideas

Here are some specifics on the 10 balanced (stock and bond mix) funds featured in the accompanying story. These funds beat the average balanced fund’s performance over the last three and five years despite taking less risk than their average peer fund, according to key risk measures used by fund tracker Morningstar Inc. Shown are year-to-date and five-year (annualized) return figures through Friday. Also shown are the funds’ current yields (from dividend and interest income) and their asset mixes as of July 31.

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Total return Current Asset Fund YTD 5 yrs. yield Stocks Bonds Flag Investors Value Builder +7.7% +17.5% 2.1% 56.9% 29.2% UAM FPA Crescent* +2.8 +16.8 2.5 46.4 13.7 Janus Balanced* +15.2 +16.7 1.9 48.0 32.0 Gabelli Westwood Balanced* +4.2 +16.6 2.2 60.8 39.2 Invesco Total Return* +5.7 +15.9 2.7 64.6 32.1 Vanguard Wellington* +5.7 +15.8 3.5 62.3 37.4 Mairs & Power Balanced* +6.0 +15.6 2.4 64.1 27.6 Capital Income Builder +5.1 +14.8 3.8 65.2 17.4 Vanguard Star* +5.7 +14.4 3.0 62.7 25.0 Fidelity Puritan* +8.0 +14.4 3.1 63.0 31.6 Avg. balanced fund +5.6 +12.4 2.3 55.7 34.7 Avg. domestic stock fund +5.0 +15.6 0.5 85.2 6.4

mix Fund Cash Other Flag Investors Value Builder 9.3% 4.6% UAM FPA Crescent* 26.4 13.5 Janus Balanced* 1.0 19.0 Gabelli Westwood Balanced* 0.0 0.0 Invesco Total Return* 3.3 0.0 Vanguard Wellington* 0.1 0.3 Mairs & Power Balanced* 4.7 3.6 Capital Income Builder 16.8 0.7 Vanguard Star* 12.3 0.0 Fidelity Puritan* 4.5 0.9 Avg. balanced fund 6.7 2.0 Avg. domestic stock fund 5.8 2.3

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Note: Asset mix figures may not add up to 100% because of rounding.

*No-load fund

Source: Morningstar Inc.