The market volatility isn't over yet. So here are funds that will offer a smoother ride. By Katy Marquardt, Staff Writer August 17, 2007 That's it? The Fed cuts an interest rate that many economists consider meaningless, the correction ends and a potential bear market is nipped in the bud?That's sure what it looks like -- at least on the surface. The market surged on August 17 after the Federal Reserve Board cut its discount rate, the rate it charges banks that want to borrow directly from it, by one half of a percentage point. The Dow Jones industrials jumped 1.82% to close at 13,079. Standard & Poor's 500-stock index and the small-company Russell 2000 index did even better, rising 2.46% and 2.24%, respectively. RELATED LINKS Five Funds for Smoother Sailing Investors Guide to Volatile Markets We're not market timers. We don't think anyone can forecast the short-term fluctuations of the markets consistently well enough to make such an endeavor worthwhile. So we don't know if the Fed's move really does mark the end of the correction. But we are confident in saying that the discount-rate cut, which many economists view as a precursor to a reduction in the more-important Federal Funds rate, doesn't guarantee that the correction is over. Consider this: The Fed last began cutting short-term interest rates in January 2000, in the middle of a cataclysmic bear market. But stock prices didn't bottom until October 2002, 22 months after the cuts began. Advertisement So what should fund investors be doing now? As always, volatile markets -- to be more precise, markets exhibiting volatility to the downside -- are a good excuse for re-examining your personal tolerance for risk and sharp swings in the value of your investments. If thrills and spills aren't your style, consider trading in your riskier stock funds for some that offer a smoother ride. We've put together a list of funds built to avoid catastrophic losses and generate decent long-term gains. Anyone can reduce risk by investing in balanced funds or other hybrids that, as a matter of policy, don't invest 100% of assets in stocks. With one exception -- T. Rowe Price Capital Appreciation -- all of our low-risk picks are essentially pure-stock funds. Unless stated otherwise, all returns are through July 31. T. Rowe Price Capital Appreciation (symbol PRWCX). This fund, which contains a blend of stocks and bonds, earns a mention because of its long record of avoiding calendar-year losses. Capital Appreciation has generated positive returns in each of the past 16 years (the jury is still out on 17; the fund was up 1% in 2007 through August 15.) Bargain-priced stocks with above-average yields make up the stock portion of the portfolio, which currently accounts for 60% of assets. The fund also has 10% in convertible bonds, 11% in intermediate-term Treasuries, and 17% in cash. Manager David Giroux says his stock-picking strategy is all about taking calculated risks. "We want to find a stock that's so washed out that there's not a lot of downside," he says. "We draw a case where, if we're right, we get a better-than-market return, and if we're wrong, we don't lose a lot of money." Lately, Giroux has been finding bargains in such growth stocks as Wal-Mart (WMT) and Cardinal Health (CAH). Advertisement This fund does more than guard the downside: its annualized 11% return over the past decade beat Standard & Poor's 500-stock index by an average of five percentage points a year. Although Giroux has only been with the fund since July 2006, we see no reason to worry. T. Rowe is a collaborative firm with a reputation for grooming solid managers, and Giroux has been an analyst with the company for nearly a decade. T. Rowe Price Equity Income (PRFDX). When safety is paramount, funds that specialize in dividend-paying stocks are a good bet. This fund is one of the best income-oriented stock funds around (and at $24.3 billion in assets, it's also one of the biggest). Brian Rogers, who has steered the fund since its 1985 launch, delivers consistent gains with below-average volatility by investing primarily in dividend-paying, out-of-favor stocks. During his 21 years at the helm, the fund has lost money in only two calendar years. Rogers, who is also T. Rowe's chief investment officer and the company's chairman, aims to keep the fund's yield at least 25% higher than that of the S&P 500 index. And he looks for stocks trading at historically low price-earnings ratios. Rogers often invests in companies that are struggling with temporary setbacks but that he feels are likely to correct their problems. Over the past 20 years, Equity Income, a member of the Kiplinger 25, has gained an annualized 11%, an average of one percentage point a year better than the S&P 500. Jensen Portfolio (JENSX). This disciplined fund seeks large, growing companies: a slice of the market that's beginning to stir after a seven-year slumber. Quality rules at Jensen, a one-fund shop in Portland, Ore. The firm's four-man investment team only considers companies that have produced a return on equity (a measure of profitability) of at least 15% in each of the past ten years. If a current holding fails the 15% test, it's booted from the portfolio and banned for at least ten years. "We see it as an indication that the company's competitive advantage has eroded," says co-manager Bob Millen. The return-on-equity requirement whittles the Jensen's universe down to 170 companies, only 25 to 30 of which make the final cut. Advertisement This process steers Jensen toward defensive, big-brand companies like Coca-Cola (KO), PepsiCo (PEP), Procter & Gamble (PG), and Colgate-Palmolive (CL), which have all held up relatively well over the past month. Millen says the fund also favors companies that generate a large portion of their revenues overseas. The team uses a long-term investing horizon. When assessing a stock for the portfolio, the managers typically consider its ten-year outlook. "Our mentality is to think in terms of buying the whole business, not just the stock," says Millen. If you're thinking about investing in Jensen, make sure you intend to hold onto it for a while. The fund tends to lag its peers when more-speculative stocks lead the way, as they did in 2003. But the patient are rewarded at Jensen. Over the past decade, the fund's 8% annualized return beat 70% of its rivals, and it did so with about one-fifth less volatility. Yacktman Fund (YACKX). When the market takes a nosedive, having a nearly a fifth of your portfolio in cash seems awfully cushy. Just ask Donald Yacktman, manager of the Yacktman Fund. From the market's peak on July 19 through August 15, the $346 million fund lost 5%, versus 9% for the S&P 500. But Austin-based Yacktman Tex., has more than than a wad of cash on its side. The fund, which buys companies of any size, focuses on highly profitable businesses that generate loads of cash and sell at discounts to their intrinsic value, or true worth. "These companies are like escalators, not moving sidewalks," says Yacktman, who co-manages fund with his son, Stephen. "They compound your money, and meanwhile, they tend to be relatively defensible." Half of the fund's assets occupy the top ten positions in Yacktman's 31-stock portfolio, which is filled with mostly large, consumer-oriented companies. Together, Coca-Cola and PepsiCo recently accounted for nearly 20% of assets. Currently, Yacktman says he's finding opportunities in financial stocks. "This is where the true bargains are, because the market is really nervous about these companies," he says. Advertisement The same pile of cash that's helping Yacktman now has held the fund back over the last three years. During that period, it returned an annualized 9%, more than three percentage points less than the average fund that focuses on large, bargain-priced stocks. "When the market goes up, our cash tends to build, and when the market goes down, we put that cash to work," says Yacktman. The fund tends to deliver during times of market turmoil: it managed a 39% gain during the 2000-02 bear market. Like Jensen, Yacktman is a fund best suited for long-term investors because stock picks can take years to play out. The fund's 8% annualized return over the past decade beat the S&P 500 by an average of two percentage points a year. Dodge & Cox International (DODFX). Foreign stock markets are increasingly moving in tandem with U.S. stocks. Still, the correlation is not perfect, and a well-diversified portfolio should contain some foreign stocks. Plus, most foreign-stock funds offer the benefit of having your money in currencies other than the dollar. Unfortunately, many of the safest overseas funds either levy an upfront sales charge, as with Thornburg International Value (TGVAX), or are closed to new investors, in the case of Tweedy, Browne Global Value (TBGVX) and First Eagle Overseas (SGOVX). A good choice for no-load investors is Dodge & Cox International, a member of the Kiplinger 25. This value-oriented fund, managed by a nine-person committee, focuses on large, quality companies in developed markets. Western Europe accounts for just over half of the fund's assets, and 20% rests in Japanese companies. Emerging markets make up about 15% of the portfolio. The fund holds 100 stocks, diversified throughout all industries. Top names in the portfolio recently included Nokia (NOK), GlaxoSmithKline (GSK) and HSBC Holdings (HSBC). The folks at Dodge & Cox do their homework: In-house analysts often spend months researching a company before making a purchase recommendation; they also subject stock candidates to a range of scenarios to determine what could go wrong. Turnover in the fund is an extremely low 9%, which implies that holds the average stock for about ten years. Dodge & Cox's low-key strategy yields impressive results. The fund has ranked within the top 30% of its international category in each of the past five years, gaining 25% annualized during that period, an average of five percentage points per year ahead of its peers.