Huge profits are waiting to be made in distressed securities.

The challenges, as in most investment opportunities, are: 1) when to get in and 2) which distressed securities to buy.

As for when to get into distressed securities, it's doubtful that anyone really knows. With the credit crunch still bombarding the financial sector, inflation and strapped consumers squeezing profit margins and interest rates on the ascent, now would seem like a horrible time. But markets are notoriously early in anticipating recoveries, so maybe a turnaround is closer at hand than most investors suspect. In fact, no one knows for sure.

A prudent answer to the second problem -- which distressed assets to buy -- is, like with many investment decisions, diversify your holdings.

One way to achieve diversity in this risky area is by buying shares in mutual funds that invest in distressed securities. Many offer the added advantage, for those uncertain of timing, of "dollar cost averaging" programs where investments are spread out over time.

The quartet of funds in the accompanying table were identified by parsing TheStreet.com Ratings database for those with stated objectives that included intentions of investing in distressed securities.

The list includes two open-end mutual funds that invest in, among other things, distressed company equities and debt instruments. In addition, it contains a pair of closed-end funds committed to focusing on distressed fixed-income investments.

The stated objective of the

Franklin Mutual Recovery Fund

(FMRAX)

, is to "achieve superior risk-adjusted returns with a moderate correlation to the U.S. equity markets" by investing in equity and debt instruments in the three categories.

"Such investments," the Franklin fund continues, "can be either long or short positions and can utilize a limited amount of leverage. The fund seeks investments in distressed companies, risk arbitrage, securities special situations/undervalued securities."

Nonetheless, the recent top holdings of FMRAX,

Weyerhaeuser

(WY) - Get Report

and

CVS

(CVS) - Get Report

, wouldn't seem like horribly distressed companies.

The

Masters Select Focused Opportunity Fund

(MSFOX)

states a belief that "limiting the number of holdings improves the long-term return opportunity because the portfolio contains only the sub advisor's highest conviction ideas."

MSFOX's continues that it "invests in distressed companies, which involve the purchase of high yield bonds, bank debt or other indebtedness of such companies."

Its largest holdings are listed as

American Express

(AXP) - Get Report

,

Salesforce.com

(CRM) - Get Report

and

Schlumberger

(SLB) - Get Report

, firms not on many current distressed-company rosters.

The closed-end

Highland Credit Strategies Fund

(HCF)

states that it will pursue its objectives by investing primarily in "secured and unsecured floating and fixed rate loans, bonds and other debt obligations, debt obligations of stressed, distressed and bankrupt issuers, structured products, including but not limited to, mortgage-backed and other asset-backed securities and collateralized debt obligations and equities."

HFC adds potential geographic diversification by stating that it may invest in securities traded in foreign countries and denominated in foreign currencies."

The

Pioneer High Income Trust

(PHT) - Get Report

states that it seeks "current income by investing at least 80% of its net assets in high yield -- below investment grade -- debt securities, convertible securities, loans, distressed securities and preferred stocks."

Richard Widows is a senior financial analyst for TheStreet.com Ratings. Prior to joining TheStreet.com, Widows was senior product manager for quantitative analytics at Thomson Financial. After receiving an M.B.A. from Santa Clara University in California, his career included development of investment information systems at data firms, including the Lipper division of Reuters. His international experience includes assignments in the U.K. and East Asia.