Balanced Funds Take the Edge Off Stocks

There's a Wall Street adage that says the only thing that goes up in a bear market is correlation. That certainly held up last autumn. Everything that didn't have "Treasury" in its name took a tumble in late 2008, including most bond classes. Still, funds that invest in a combination of stocks and bonds managed to do their job of mitigating losses.

The average fund in Morningstar's "moderate allocation" category, which includes funds that invest 50% to 70% of their assets in stocks, lost 28.0% in 2008. That's no treat for investors, but at least it was far better than the 37.0% loss for Standard & Poor's 500-stock index.

A balanced fund might be the ticket if you want to move into stocks but are worried that the market could surrender some of its recent gains. Another benefit of going balanced? Because most balanced funds stay close to a set asset allocation-such as 60% in stocks and 40% in bonds-managers must pare stock holdings when shares enjoy big runs and are forced to buy more stocks when the market falls. In other words, buying low and selling high is built into the DNA of balanced funds. By contrast, an individual who is trying to maintain a balanced portfolio may have trouble acting because it can be difficult to sell winners and buy laggards.

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Vanguard Wellington (symbol VWELX) is an institution in the world of balanced funds. The 80-year-old fund-founded just before the 1929 stock-market crash-is one of the oldest mutual funds in existence. And with $40 billion in assets, it is one of the largest balanced funds today.

But neither age nor girth has hampered its steady, peer-beating returns. Over the past ten years through June 13, the fund returned 4.6% annualized, topping similar funds by three percentage points per year, on average. And Wellington has been a model of restraint in hard times-the fund nearly broke even during the 2000-02 bear market, losing just 0.8%. And its 35.8% loss during the recent debacle, from October 9, 2007, through March 9, 2009, stacks up well against its peers' 40.7% decline. (The S&P 500 lost 55% during the bear market.) Hand partial credit for those returns to the fund's minuscule expense ratio of 0.35% per year.

Given the fund's size, the managers won't even consider a stock unless it has a market capitalization of at least $8 billion. Ed Bousa, who picks stocks for Wellington, says an ideal holding is a company that is gaining market share, has a decent balance sheet and pays a respectable dividend. "We're trying to identify companies that will be winners in this capital-constrained environment," he says.

John Keogh, who manages the bond side of the portfolio, says his job is to provide a "buffer in case of a bad equity market." But that doesn't mean he just sits on a pile of Treasuries, which account for only 1% of the fund's assets. He's moved most of the bond stake into high- and medium-quality corporate issues, which he says offer better opportunities.

Not many funds can claim to offer the broad diversification of T. Rowe Price Personal Strategy Balanced (TRPBX). It invests in large-cap, small-cap, domestic and foreign stocks, and in a range of debt instruments, including Treasuries, foreign issues and junk bonds. That approach recently resulted in a portfolio that recently held some 665 stocks and 555 bonds. You get all that diversification for a reasonable 0.76% expense ratio.

The fund operates as though it is a fund of funds, says lead manager Ned Notzon. Once a month, T. Rowe Price's allocation committee meets to consider whether there are any beaten-down areas the fund should stock up on or any asset classes on a tear that should be trimmed. "We always balance back to take profits off the table when a position exceeds its targeted weight," Notzon says. "You can't count on things continuing to march up all the time."

The team forms target asset allocations for the fund and then invests in baskets of stocks that mimic existing T. Rowe Price offerings to reach those targets. Right now the fund has more money in stocks than usual, with 51% invested in U.S. companies and 15% in foreign issues.

The fund suffered along with everything else during the bear market, losing 41.3%. Historically, it lags the S&P 500 moderately in good times and beats it handily in bad times, as a good balanced fund should. Over the past ten years it returned 3.7% annualized.

In contrast to the T. Rowe Price fund's frenetic diversification, Oakmark Equity & Income I (OAKBX) shows how far simplicity and focus will go. The fund held just 38 stocks, at last report, balanced by a load of Treasuries. Over the past ten years, it returned 8.4% annualized, beating 99% of similar funds. The stake in Treasuries helped contain losses to 26.9% during the 2007-09 bear market.

Managers Clyde McGregor and Ed Studzinski pick from a list of approved stocks that the team of analysts and managers at Oakmark develop collaboratively. "We're looking for companies that grow their intrinsic value over time, where managers treat shareholders as partners," McGregor says. The pair prefer to buy stocks at deep discounts to what they think a company is worth. "We're looking for 60 cents on the dollar," says McGregor.

He says the fund represents his largest personal investment. "We invest as though the portfolio represents our mothers' money," says McGregor. "My mother is a retired music teacher without large savings, and she can't afford to do anything that would jeopardize her future."

If Mairs & Power Balanced (MAPOX) had a motto, it might be "Buy what you know, and hold it forever." Bill Frels, who has managed or co-managed the fund since 1992, focuses on midwestern companies (Mairs & Power is based in Minnesota) and typically holds stocks for ten years. "We're looking for companies that can sustain an above-average rate of growth, and we try to buy them at an attractive valuation," he says.

That's easier said then done, but Frels has the record to back up his words. During his tenure, the fund gained 8.5% annualized, beating its rivals by an average of nearly three percentage points per year. The fund is currently heavy on medium-quality corporate bonds and health-care and financial stocks.

If you're uncomfortable with the 60%-40% stock-bond mix that is typical of balanced funds, take a look at the Manning & Napier Pro-Blend lineup. Manning & Napier, a low-profile shop based in Fairport, N.Y. (near Rochester), offers funds with different stock-bond mixes, each of which can be altered depending on management's view of the markets. The most conservative fund, Manning & Napier Pro-Blend Conservative Term Series (EXDAX), can hold as much as 29% in stocks and as little as 6%. And the most aggressive fund, Manning & Napier Pro-Blend Maximum Term Series (EXHAX), can invest between 73% and 96% of its assets in stocks.

The firm uses an elaborate team process to manage the funds. The views of 13 economists on staff form the backdrop for the work of 32 stock analysts and six bond analysts. Ultimately, the firm's most senior analysts vote on each stock being considered. Although it's tough to get a sense of the character of management when so many minds are involved, performance figures should instill some confidence: Each of the four funds lands within the top 5% of its peer group over the past ten years.