Sturdy Hybrid Funds for Shell-Shocked Investors

The free-fall in the equity markets has understandably spooked investors. The S&P 500 Index has lost 41% for the year to date through Nov. 17, 2008, and many stock funds that focus on smaller companies or non-U.S. firms have posted even bigger declines. We think this is a bad time to give up on stocks, which unfortunately is what many investors seem to be doing--mutual fund outflows have soared. For some, however, the bear market may serve as a rude awakening that their asset allocation plan was too aggressive. Those who are more risk-averse or have shorter-term savings goals in mind could be better served by a fund that owns a slug of fixed income in addition to equities. There are a number of fine choices in the moderate-allocation, conservative-allocation, and world-allocation categories that fit the bill. True, these funds have taken hits this year as well, and not just from their equity stakes--most types of bonds have lost money, too. But their shareholders haven't suffered as much damage to their nest eggs--the typical moderate-allocation fund (which holds 50% to 70% in equities) has lost 32%, the typical conservative-allocation fund (20% to 50% in equities) has lost 22%, and the typical world-allocation fund (less than 70% in stocks and at least 40% in foreign stocks and/or bonds) has lost 34%.

In order to narrow down the universe of 500-plus funds across these categories and identify some attractive options, we used Morningstar's  Premium Fund Screener. We searched for funds in the three categories that have managers who have spent at least 10 years at the helm and that have outpaced 75% or more of their category rivals over that span. We also wanted to focus on funds that have navigated the current turbulence relatively well, so we excluded those that didn't land in their category's top quartile for the year to date through Nov. 17, 2008. Of course, we also wanted funds that are within reach of a broad range of investors (minimum purchase of $10,000 or less) and charge lower expense ratios than their typical rivals. Finally, we narrowed the list to funds covered by our analysts, in part because these categories include some oddball funds that require some serious peeking under the hood before purchase. The screener pulled up six funds;  here's the full list.

One of our favorites on this list is moderate-allocation offering  Oakmark Equity & Income  (OAKBX). It has been run since its 1995 inception by Clyde MacGregor (Ed Studzinski joined as comanager in 2000) and boasts a superb long-term record. The fund's bond portfolio is a plain-vanilla collection of Treasury bonds--one reason this fund hasn't become an Analyst Pick in its category is that it isn't supported by a dedicated fixed-income team at the firm. However, a value-oriented stock-picking approach that favors companies with healthy balance sheets has won the day here. We're not the only ones who like MacGregor--he was recently chosen by Litman/Gregory to run slices of  Masters' Select Equity (MSEFX) and  Masters' Select Value .

Another intriguing choice is  FPA Crescent (FPACX). Managed by Steve Romick since its 1993 inception, it doesn't look much like the typical moderate-allocation fund--Romick focuses primarily on small- and mid-cap firms, will sometimes sell stocks short (a bet that their prices will decline), and often holds a bigger stake in cash than bonds. He's racked up a superb record over the long haul. The fund's emphasis on smaller fry means it's more of a supporting player than a core holding, but it's a fine choice.

For investors seeking far less equity exposure,  Vanguard LifeStrategy Income (VASIX) is a sensible option. Its equity weighting can swing from 5% to 30%, because this fund of funds plows a quarter of its assets into  Vanguard Asset Allocation  (which shifts between the S&P 500 Index and Treasury bonds, depending on management's forecasts for long-term equity and bond returns). The rest of this fund is stashed in  Vanguard Total Bond Market (VBMFX),  Vanguard Short-Term Investment-Grade (VFSTX), and  Vanguard Total Stock Market (VTSMX). The result? Broad exposure to bonds and stocks, a very low price tag (0.25%), and a relatively smooth ride. Despite a rare bad call at Asset Allocation that has led to steep losses, this fund has declined a fairly modest 15% in 2008.

Unfortunately, only one world-allocation fund made the cut: Analyst Pan  Evergreen Asset Allocation (EAAFX), which we would avoid due to its holdings in difficult-to-trade mortgage bonds that limit its flexibility, as well as fees that Evergreen layers on top of the cheap underlying funds (which are managed by GMO). Also, the fund's long-term record is distorted by the inclusion of the results of the far cheaper GMO fund that Evergreen adopted. Instead, we'd steer investors to  American Funds Capital Income Builder (CAIBX). True, the fund's eight managers have served on the fund for less than 10 years, on average, but there are many experienced investors on board. The fund has lost almost as much money as its typical rival in 2008, but it has fared well over the long haul. It benefits from American's massive analyst staff, and it boasts a very modest 0.55% expense ratio.

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