Low-Risk Stock Funds
After many years of investor uninterest, the recent bear market has shown the merits of low-risk funds. Sure, these cautious funds are never going to offer fabulous 20% annualized returns even during the best of times. But risk-averse fund managers are just the kind of people you want managing your money when things aren't so rosy or when you know you're going to need to pull money from the fund in the near future.
That's not to say you want managers who are so paralyzed with fear that they run their portfolios like money-market funds. And you definitely don't want managers who are trailing the market because of their own incompetence, rather than their aversion to risk. The key is to separate the intelligently cautious from the totally clueless.
That was the guiding principle behind these low-risk stock-fund picks. Our fund-screening system ranks funds based on their three-year returns, with an eye to their volatility as measured by the standard deviation of their monthly returns over the past three years. That means we penalize the funds that top the charts one month and tumble the next. Steady performance is rewarded.
The screen also punished funds with sales charges -- a real rip-off if you're going to be holding these funds for only a few years), high turnover and above-average expenses. Ultimately, we selected the least-risky funds, cutting those with a minimum-investment requirement over $10,000, since it would be hard for many people to buy the three or more funds they need for a diversified portfolio if the minimums were that steep.
Bonds and Bond Funds
As boring as they may be, you can't ignore bonds in a safe-investment portfolio. They may not soar like stocks, but they won't crash and burn, either.
If you are willing to put in the effort, you're better off buying individual bonds instead of bond funds. You can tailor a portfolio of bonds to meet your circumstances, meaning the bonds will mature precisely when you need the funds. And by holding bonds to maturity, you eliminate the risk that rising interest rates will cut into your investment.
When it comes to individual bonds, we like Treasury strips, which are easy to buy and sell, and offer guaranteed returns if you hold them to maturity. Strips are created by the big Wall Street bond houses, which clip interest-bearing coupons from long-term Treasury bonds. The strips are essentially zero-coupon bonds, meaning you buy them through your broker at a discount to face value -- say $4,200 for a $5,000 bond--and you get the full value at maturity with no interest payments in between (see our Bond section for more on zeros). Strips are generally purchased at a face-value minimum of $5,000, though some brokers will sell them in smaller denominations.
Don't feel you have to buy only strips that mature exactly when you know you'll need them. Sure, that eliminates your risk, but it also might leave you with pretty meager returns. To boost returns, experienced bond investors create what's called a laddered portfolio of strips, buying different maturities -- some longer and some shorter than their target date. You get more yield on the longer maturities, but your risk is tempered by the bonds that will mature before you need them.
If interest rates rise, you will lose money on your longer-term bonds, but you'll most likely make it back when you buy new bonds at the higher rate using the proceeds from your maturing bonds. The big discount brokers, like Schwab and Fidelity, offer laddered portfolios of strips with three maturities, and their quoted yields include the commission. Fidelity, for example, charges $150 for a ladder of three bonds. You can pay less by using one of the deep-discount brokers.
If all this talk about maturities and interest rates is too much to deal with, you should probably buy a bond fund. True, you will take on some added risk, because you will never find a fund whose portfolio exactly matches your needs. But the funds we recommend are so tame, and so much easier to deal with than individual bonds, that the trade-off is probably worth it.
Loan-Participation Funds
Until recently, loan-participation funds have represented a relatively small (and largely undiscovered) sector of the investing world. For the past decade, just a dozen or so have been open to retail investors. But the healthy long-term returns of this small group have prompted other firms to roll out offerings, and this competition has been driving down fees and increasing your options.
Loan-participation funds invest in loans that are made by banks to companies with low credit ratings. That means the risk of default is higher -- sometimes too high -- but the income, or interest rate, from the loan is higher. If you were owed a single loan, the risk wouldn't be worth it. But the fund manager's job is to invest in enough of these loans that the blended risk is minimized. Also, since these loans are considered senior secured debt, they are the first loans that are paid off if a company goes bankrupt. That means the lenders typically recover about 75% of any defaulted loans.
The results for investors have been good, especially when you consider that loan-participation funds balance out our short-term bond selections, since each fund type suffers during different parts of the economic cycle. When the economy is humming and the Fed raises interest rates, bond funds suffer but the yield on loan-participation funds rises. For example, from 1994 through 1998 -- when the recent bull market was at its strongest -- loan-participation funds delivered more than 7% a year on average, while short-term bond funds gained 5.5% annualized. More recently, as recession set in, these fund groups traded places: Short-term bond funds are up almost 6% annualized from 1997 through mid-December 2001, while loan-participation funds gained 4.5%.
Loan-participation funds are certainly not risk free. Their gains weakened significantly in 2000 and many fell into negative territory in 2001: During a recession the loans these funds invest in are more likely to go into default. There's also another downside: lack of liquidity. You can buy into these funds at any time, but many of them can only be sold once a quarter, so you have to know when you're going to need your money.
Our advice is this: These funds are worth the risk unless there are clear signs that the economy is turning downward, or if you'll need the money within the next 12 months. You'll have to keep an eye out, but the extra returns are worth it.
