Funds for Volatile Markets

September 10, 2015

fb-ferriswheel-stockbondfundsThis post by FundX President Janet Brown originally appeared on Forbes.

“I can’t take the volatility of being entirely invested in stock funds,” an investor told me.

“But I’m also wary of bond funds because I’m concerned about what will happen when interest rates rise.”

This is a common concern I hear from the investors I talk with.

With volatile stock markets and the bond market threatened by higher interest rates, some investors simply aren’t sure where to turn.

Balanced funds and some alternative funds can be good solutions for more conservative investors. These funds typically have more upside potential than bond funds and less volatility than most stock funds.

Most of the balanced and alternative funds in NoLoad FundX newsletter lost about half as much as the S&P 500 in August 2015 when markets sold off sharply. And, on average, these funds lost about 40% less than the S&P 500 from the October 2007 peak to the March 2009 low.

But there are a few things you should know before buying into balanced and alternative funds.

Balanced Funds Aren’t All Alike

Balanced funds invest in stocks for growth and bonds as a buffer against volatility. The classic balanced fund tends to invest in U.S. stocks and bonds, allocating 60% to stocks and 40% to bonds, but there are many variations to consider. Dodge & Cox Balanced (DODBX), for example, can have up to 75% invested in stocks, while Vanguard Wellesley Income (VWINX) has a static allocation of 66% in bonds and the remainder in stocks.

Balanced funds also differ by the types of stocks and bonds they hold. Villere Balanced (VILLX) has exposure to small-and mid-cap stocks, while Janus Balanced (JABAX) focuses on large caps. American Beacon Balanced (AABPX) has more exposure to government bonds, while Mairs & Powers Balanced (MAPOX) has a larger position in corporate bonds. Fidelity Global Balanced (FGLBX) can invest in foreign stocks and bonds, while Villere Balanced invests solely in the U.S.

Balanced funds with more exposure to stocks are designed to do better when stock markets are rising, while funds with more exposure to bonds are designed to do better when stock markets are weak.

But what happens if both stock and bond markets decline? That’s where alternative funds come in.

Alternative is a broad fund category

‘Alternative’ is a broad category that includes both riskier and more conservative funds. Some alternative funds are concentrated in just one area of the market, like gold, commodities and real estate. The more conservative alternative funds, on the other hand, aim to provide lower-than-market volatility by hedging their portfolios with options, arbitrage or alternative assets (such as precious metals). Because these funds tend to have less exposure to bonds than classic balanced funds, they often have less interest-rate or credit risk.

A fund like PowerShares S&P 500 Buy-Write (PBP), for example, invests in the S&P 500 index and then sells covered call options on the index. Options pay a premium, and this income can help cushion market declines.

Merger Fund (MERFX), on the other hand, seeks to arbitrage the spread between the price of a company being acquired and the company that is doing the buying. The fund will go long on the target company and sell short the acquirer’s stock. Because funds like MERFX are both long and short, they are typically less volatile than a long equity fund.

How to Choose Balanced & Alternative Funds

So if you want to own less volatile funds, which funds should you choose?

It helps to have a strategy that can identify which funds to own now and when to move into other funds.

In NoLoad FundX, we group balanced and alternative funds together, and then we invest in funds that have the best recent returns. This way, you’ll be led to own alternative funds when they’re doing well and own balanced funds when they are bringing in better returns.

In 2008, when stock and bond markets sold off, NoLoad FundX’s conservative “Class 4” portfolio owned alternative funds like Merger Fund and Permanent Portfolio (PRPFX) and more conservative balanced funds like Vanguard Wellesley Income, which is primarily invested in bonds.

As the stock market recovered, the portfolio moved into balanced funds that had more exposure to stocks, like Mairs and Powers Balanced and Fidelity Balanced (FBALX), both of which have about 60% in stocks.

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