We get off the mat by adding seven new funds that match up well against hostile markets. By Nellie S. Huang, Senior Associate Editor From Kiplinger's Personal Finance, May 2016 Everyone has a plan, boxer Mike Tyson once said, until he gets punched in the mouth. The stock market has delivered a couple of vicious blows to investors over the past year, leaving them dazed and wondering whether it’s time to throw in the towel on a bull market that is looking shaky and tired.See Also: 25 Best Mutual Funds for Low Fees But, as even Tyson understood, it’s how you react after you get hit that matters. The best reaction may be none at all. In particular, you shouldn’t panic, which you’re less likely to do if you look at the market’s recent declines in context. After more than tripling since 2009, Standard & Poor’s 500-stock index last year endured its first correction (a drop of 10% to 20%) since 2011. The S&P first fell 11.9% from May 2015 through August, with nearly all of the damage occurring during the week of August 17. The index then recovered, only to plummet 10.3% in the first six weeks of 2016. All told, the S&P 500 lost 6.2% over the past 12 months. (All returns are through February 29 and include reinvested dividends.) The correction could still morph into a bear market (a decline of at least 20%). But with the U.S. economy performing decently—Kiplinger expects gross domestic product to expand by 2.5% in 2016—and with a recession unlikely, a bear market would be “short and shallow,” says Katie Nixon, a strategist with Northern Trust. Advertisement Still, if you hold any of the stock funds in the Kiplinger 25, the list of our favorite actively managed, no-load mutual funds, you’ve felt the sting of the market’s one-two punch. The group’s 12 U.S. stock funds lost 9.0%, on average, over the past year. “If investors didn’t know their pain point before, they know it now,” says Omar Aguilar, chief investment officer of stocks at Charles Schwab Investment Management. No one can say for sure what the markets will do next, particularly over the short term. But it appears that the coming year will be a slog for U.S. stocks, with volatility high and returns, at best, in the mid-single-digit percentages. “Oil, China, the Federal Reserve’s interest rate action or inaction—pick your poison, we won’t get through them in the next six, nine, or even 12 months,” says Nixon. So what’s an investor to do? Don’t let a hard blow cause you to radically revamp your plan. But that doesn’t mean you have to sit on your hands, either. Smart investors can play either offense or defense, boosting exposure to hard-hit parts of the markets or shoring up their portfolios with “defensive winners,” funds that hold up well in hostile environments, says Jeff Speight, a certified financial planner in Houston. We’re doing a bit of both in this year’s version of the Kiplinger 25, which contains more changes than usual. In several instances, we’ve ousted funds whose performance has not lived up to expectations. In some cases, we simply found cheaper, better-performing alternatives. And in others, we decided to switch strategic gears. What follows is an introduction to the newest members of the Kip 25. Advertisement American Century Equity Income (symbol TWEIX) This fund is all about defense. It has been about one-third less volatile than the S&P 500 over the past decade, a trait that has paid off in rough markets. It lost 39.2% during the 2007–09 bear market (when the S&P dived 55.3%) and 14.1% during the 2011 correction (when the index fell 18.6%). The fund’s 6.5% annualized return over the past decade just edges the index. “We’re the tortoise in the tortoise-and-hare race,” says Kevin Toney, who manages the fund with Phil Davidson, Dan Gruemmer and Michael Liss. “We win by not losing.” Two elements of the fund’s strategy provide protection in down markets. First, the managers invest most of the fund’s assets in high-quality, dividend-paying stocks. They also place about 20% of assets in convertible stocks and bonds, as well as in straight preferred stocks, all of which tend to be less volatile than common stocks. One of Equity Income’s biggest holdings is a Wells Fargo preferred stock that yields a whopping 6.6%. The fund itself yields 2.4%. T. Rowe Price Blue Chip Growth (TRBCX) Larry Puglia, a comanager of the fund when it opened in 1993 and sole manager since 1997, is in his investors’ corner. He has socked more than $1 million of his own money into the fund and “never sold a share,” he says. Good move. Since Blue Chip’s launch, it has earned 9.8% annualized, beating the S&P 500 by nearly one percentage point per year, on average. Puglia is a proven stock picker. He favors well-run companies with steady growth prospects that are managed by execs who reinvest wisely in the business and that trade, he says, at “acceptable” prices. At last report, Blue Chip owned all of the FANG stocks—Facebook, Amazon.com, Netflix and Google (now called Alphabet)—which helped performance last year but have been nettlesome this year. Advertisement Vanguard Health Care (VGHCX) After a long absence, this sector fund returns to the Kip 25. We added Health Care to our list in 2004, but, as is our policy, we removed it the next year after the fund closed to new investors. As an analyst with the fund since 1995 and a manager since 2008, Jean Hynes has seen a lot of change in the industry. Much of it has come in recent years: electronic medical records, Obamacare and the revolution in biotechnology. “When I think about my 25-year career, this is the most exciting time for innovation in this sector,” says Hynes. She and her Wellington Management team of 11 analysts and researchers have a proven process. Within three basic areas—drugs (including biotech), devices and services—they favor large, undervalued firms with good growth prospects over the next five to seven years. The fund’s biggest holdings are Allergan, Bristol-Myers Squibb and UnitedHealth Group. The approach is one of the tamer ones among health-sector funds, and the result is what you might expect: The fund lags during powerful advances, but it holds up better in lousy markets. Hynes may not want to crow about her fund’s 6.0% loss over the past year, but that beat the average health fund by 10.2 percentage points. Advertisement Vanguard Wellington (VWELX) In general, we think investors should build their own balanced portfolios, using the best and most appropriate stock and bond funds. But if you can’t abide watching a pure stock fund tumble during market routs, consider a fund that holds stocks and bonds. Wellington, which launched in 1929, invests about two-thirds of its assets in stocks and the rest in bonds. Not surprisingly, the fund is run by Wellington Management. John Keogh has handled the bond side since 2006, and Edward Bousa has picked the stocks since 2002. Since their pairing, the fund has returned 6.7% annualized, trouncing the typical “moderate allocation” fund (Morningstar’s moniker for the balanced category) by an average of 2.7 percentage points per year. The fund yields 2.7%. Bousa invests in three kinds of dividend stocks: stable companies with above-average yields (for example, Verizon Communications); stocks that are inexpensive because of a supply-demand imbalance (Royal Dutch Shell); and “broken” growth stocks (Bristol-Myers Squibb). On the bond side, Keogh mostly holds government IOUs, which, he says, serve as a “buffer” should the economy head south. Metropolitan West Total Return Bond (MWTRX) The guiding principle of this medium-maturity, taxable bond fund is to buy at a bargain price. “If you’re disciplined and buy as prices go down and sell as prices go up, you’ll make money and do so at a reasonable level of risk,” says Laird Landmann, one of four comanagers. With a five-year annualized return of 4.5%, the fund has met its goal of beating the Barclays US Aggregate Bond index, which gained 3.6% annualized over the period. Landmann expects to see a rise in defaults over the next 18 to 24 months, so the managers have two-thirds of the fund’s assets in Treasuries and government-backed mortgage securities. The defensive crouch crimps the fund’s yield, which at 1.6% is a half-percentage-point below the index’s yield. But this is temporary, Landmann says. Corporate debt will lose value as defaults (both actual and anticipated) increase. When that happens, Landmann says, he and his colleagues will buy bonds at lower prices and higher yields (bond prices and yields move in opposite directions). Pimco Income (PONDX) This multi-sector bond fund’s long-term record is nothing short of sensational. Since Income’s launch in 2007, it has returned 8.6% annualized, trouncing the Aggregate index by an average of nearly four percentage points per year. The fund, which yields 3.4%, employs a barbell strategy that provides income on one side and stability on the other. For income, managers Daniel Ivascyn (who is also Pimco’s chief investment officer) and Alfred Murata buy junk bonds, which tend to perform well when economic growth is robust, as well as non-guaranteed mortgage securities, bank loans and emerging-markets bonds. The stable side of the portfolio, accounting for some 40% of assets, includes Treasuries, government-backed mortgage securities and high-grade corporate debt, as well as securities that benefit from falling interest rates in Australia without subjecting the holder to currency risk. Pimco expects rates in Australia to fall as its commodity-heavy economy weakens, a byproduct of China’s decelerating growth. Vanguard High-Yield Corporate Fund (VWEHX) Junk bonds have had a rough go since last June. Investors sold them in droves because of concerns about the economy in general and the health of the oil patch in particular. So we deemed this a good time to add a pure junk-bond fund to the Kip 25. But we didn’t want to be overly aggressive, so we chose one of the tamer offerings, Vanguard High-Yield. The fund focuses on losing less when things get dicey, says Wellington Management’s Michael Hong, who has run High-Yield since 2008. “It has a defensive quality,” he says. Hong keeps risk down by loading up on the higher-quality end of junk bonds. Nearly 85% of the fund’s assets are in bonds rated single-B or double-B, the highest junk rating. Over the past year, High-Yield lost 4.4%, but that beat the average junk-bond fund by 3.3 percentage points. The fund yields 6.6%. Why we added seven new funds With seven new funds, this year’s version of the Kiplinger 25 has more turnover than usual. In a typical year, we replace three or four funds. Why such a big shake-up this time? It’s partly due to the usual reasons: disappointment with a fund’s performance and analysis that leads us to conclude that another fund can do the job better. But this year we also apply some big-picture judgments about the direction of the markets and sectors within them. Three shifts stem from our top-down thinking. First, we think interest rates will remain low for a long time. That should mean more mediocre results for Merger Fund; its strategy of investing in takeover stocks after a deal is announced has been hurt by low rates. We replaced Merger with Vanguard Health Care, a conservative choice in a sector that took it on the chin over the past year. Our view on rates also prompted the removal of Metropolitan West Unconstrained Bond, which we added to the Kip 25 to protect against higher rates. Pimco Income, a multi-sector bond fund with a higher yield, replaces Met West. And we think junk bonds, poor performers since last June, have become more attractive, so we replaced Osterweis Strategic Income, which focuses on short-term low-grade debt, with a more traditional junk fund, Vanguard High-Yield Corporate. We replaced two Kip 25 members with funds that we think offer better potential. In the hybrid category, Vanguard Wellington, a classic balanced fund (one that owns both stocks and bonds), replaces the more esoteric FPA Crescent, a go-anywhere fund that has gone heavily into cash. Wellington has a big fee advantage, charging about 0.9 percentage point per year less. And Metropolitan West Total Return supplants Fidelity Total Bond. Both focus on intermediate-maturity, investment-grade bonds. Since 2011, the Met West fund has regularly outpaced the Fidelity fund, despite a slightly higher expense ratio. Our last two changes were designed to rectify some imbalances in the Kip 25 stock funds. In particular, we had too many funds that concentrated on midsize-company stocks, so we said so long to Davenport Equity Opportunities and Vanguard Selected Value. We replaced them with T. Rowe Price Blue Chip Growth, a pure large-company growth fund, and American Century Equity Income, a dividend-oriented large-company fund that also owns convertible and preferred securities.