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6 U.S. Equity Funds for Risk-Averse Investors

These funds won't keep you up at night if you're squeamish about exposing the bulk of your assets to the market.

Note: This article is part of Morningstar's May 2016 Risk Management Boot Camp special report.

When you hear the term "core holding," what do you think of? For many U.S. stock investors, an S&P 500 Index fund or total stock-market index fund is just the ticket: broad diversification for a slim fee. But for others, the idea of having the bulk of one's assets fully exposed to the market's gyrations is too nail-biting. Some investors will happily sacrifice the prospect of hitting all the markets highest notes if it means their savings is better protected when the index is falling like a stone.

To help identify some funds with the potential for capital appreciation, but also a solid record of downside protection, I employed the Morningstar Direct software. First, I screened for funds in the large-cap and allocations categories that earned one of our Medalist ratings--Gold, Silver, or Bronze. Then I ranked that subset by their 10-year standard deviations.

I included some additional criteria to winnow the list: All the funds listed below have a "low" Morningstar Risk score over the trailing 10-year period. This proprietary Morningstar datapoint assesses the variations in a fund's monthly returns, with an emphasis on downside variations. In each Morningstar Category, the 10% of funds with the lowest measured risk earn a "low" risk score.

I also looked for funds with 10-year downside capture ratios that were lower than 80. (A downside capture ratio of less than 100 indicates that a fund has lost less than a broad index (for stock categories, the S&P 500 is the benchmark; for allocation categories, Morningstar's Target Risk Indexes are used) in periods when the bogy has been in the red.) I also zeroed in on funds that ranked near their respective category's top decile during 2008, when the S&P 500 Index lost 37%.

Finally, I passed up any funds with above-average fees relative to their peer group. Here are some funds that made the cut.

Vanguard Wellesley Income

VWINX

Morningstar Analyst Rating: Gold Morningstar Category: Allocation--30%-50% Equity 10-Year Downside Capture Ratio: 44.65 2008 Return/Rank in Category: -9.84/10

Morningstar analyst Alec Lucas describes Vanguard Wellesley Income's strategy as "conservatism at its best." Equity manager Michael Reckmeyer invests about 35% of the portfolio in above-average dividend-payers, like

Berwyn Income

BERIX

Morningstar Analyst Rating: Silver Morningstar Category: Allocation--30%-50% Equity 10-Year Downside Capture Ratio: 41.45 2008 Return/Rank in Category: -10.19/11

This fund follows a so-called contrarian approach--eschewing "hot" areas of the market in favor of those that are out of favor. This hybrid fund, which falls into our Allocation--30%-50% Equity Morningstar Category, can invest as much as 30% of its assets in dividend-paying common stocks. Beyond a dividend, the managers look for companies of all sizes with improving balance sheets and good cash flow prospects that trade relatively cheaply--often because of short-term issues, says Morningstar senior analyst Kevin McDevitt. The rest of the portfolio is split among corporate bonds (including high-yield, but avoiding the lowest-rated issues), preferred stocks, and convertible securities. Like other defensive funds, this one has lagged at times during strong rallies. This owes in part to management's valuation consciousness and tendency to let cash build as prices rise. That said, the fund's return still ranked among the category’s best 2013's rally, and over the 10-year period, the fund's 6.9% return is also at the top of its category's ranks.

American Century Equity Income

TWEIX

Morningstar Analyst Rating: Silver

Morningstar Category: Large Value 10-Year Downside Capture Ratio: 63.69 2008 Return/Rank in Category: -20.1%/1

This isn't your typical large-value fund. Lead manager Phil Davidson helps this fund achieve its excellent downside protection with a steady focus on yield. His team buys only dividend-paying stocks, convertible bonds, and preferred stocks. Higher up the capital structure than equity, the latter two security types help notably reduce the fund's volatility. "The focus here is downside protection and capital preservation, which can cause performance to lag when markets rally," says Morningstar analyst Gretchen Rupp. Indeed, in a go-go market like 2013 when the S&P 500 rose 32.4%, this fund "only"rose 19.5%, landing it in the category's lowest decile. But, as Rupp points out, the fund "gets ahead by losing less": Over the trailing 10-year period, the fund has returned 7%, besting 88% of its peers.

BBH Core Select N

BBTEX

Morningstar Analyst Rating: Silver Morningstar Category: Large Blend 10-Year Downside Capture Ratio: 74.52 2008 Return/Rank in Category: -21.7%/1

Discipline is the name of the game here. Lead manager Tim Hartch and his team buy good companies at reasonable prices and hang on to them for a long time (annual turnover around 8%). They maintain a concentrated portfolio of around 30 stocks, comprising market leaders with sustainable competitive advantages, strong balance sheets, and high returns on capital and cash flows, such as

Vanguard Dividend Growth

VDIGX

Morningstar Analyst Rating: Gold Morningstar Category: Large Blend 10-Year Downside Capture Ratio: 74.52 2008 Return/Rank in Category: -25.57%/3

This fund has protected investors' capital on the downside, but has achieved a fairly decent showing in rising markets as well thanks to its "disciplined, but not rigid" focus on stocks that are growing their dividends. As Morningstar analyst Alec Lucas points out, however, this is not a high-yield fund: Manager Donald Kilbride seeks stocks that have the best prospects for steadily increasing their payouts rather than those that offer the highest current yield. (Companies that are focused on growing dividends tend to be higher quality than those that stretch to maximize payout.) The fund's 8.7% 10-year annualized returns rank among the category's elite. Investors have certainly taken notice, too—at $29 billion in assets, the fund is the largest single-manager actively managed fund in the large-blend category. However, as Lucas notes, the fund's focus on the largest, most-liquid dividend payers and its low turnover (26%) means it's a strategy that can accommodate scale.

Jensen Quality Growth

JENSX

Morningstar Analyst Rating: Silver

Morningstar Category: Large Growth 10-Year Downside Capture Ratio: 79.98 2008 Return/Rank in Category: -29.0%/2

You may be asking, what's a concentrated growth fund doing on this list? But this fund's unwavering application of its extremely disciplined investment approach means it's a good holding for investors whose tolerance for risk is a bit higher. The fund will only invest in stocks with market caps of at least $1 billion for firms that have delivered returns on equity of at least 15% in each of the past 10 years. Though the managers tend to hold on to picks for many years (annual portfolio turnover is 14%), they will sell a holding that doesn't deliver a 15% ROE or that has diminished growth prospects, says Morningstar senior analyst Greg Carlson. And due to its focus on high-quality fare, it exhibits a similar return profile similar to some of the stock/bond hybrid funds on this list: It tends to hold up much better in downturns, but it can be a bit sluggish in big rallies compared with its large-growth peers. To put that in context, however, this fund outperformed the S&P 500 by 2.5 percentage points in 2009, even though it fell into the large-growth category's lowest quartile that year.

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