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As Stocks Rise, Consider Getting Conservative

Conservative-allocation funds proved themselves during the downturn. There's still a place for them in your portfolio.

BOSTON (TheStreet) -- If you worry that stocks could be due for a pullback, consider conservative-allocation funds. They protect shareholders by putting less than half their assets in stocks and the rest in fixed income.

The cautious formula can limit losses in downturns -- and deliver decent results in bull markets. During the 12 months through Aug. 7, allocation funds lost 4.6%, a solid record in a period when the S&P 500 declined 20.5%, according to Morningstar.

While all conservative-allocation funds have big fixed-income holdings, they follow a variety of strategies. Some portfolio managers maintain static allocations, typically keeping about 60% of assets in investment-grade bonds. Other funds range widely, shifting their holdings as conditions change and investing in junk bonds and small stocks.

Among the safest choices is

Vanguard Wellesley Income

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. The fund usually keeps about 40% of assets in dividend-paying stocks and the rest in cash and investment-grade corporate bonds. The recipe may sound stodgy, but the fund has returned 5.9% annually during the past 10 years, outdoing 95% of its conservative-allocation peers and surpassing the S&P 500 by more than 7 percentage points.

Besides seeking to produce capital appreciation, the Vanguard portfolio managers aim to generate steady income. They have achieved their goal, routinely delivering annual dividend yields of more than 4%. The fund currently yields 4.9%, an attractive payout at a time when 10-year Treasuries yield 3.75%.

For some more juice, try

Berwyn Income

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, which has returned 7.3% annually during the past decade and currently yields 5%. The fund typically keeps about 30% of assets in stocks and the rest in a mix of fixed-income securities.

In 2005 and 2006, the fund emphasized high-quality bonds, holding a big stake in Treasuries. At the time, the Berwyn managers believed that yields on shakier bonds were unrealistically low. Because default rates were minimal, investors didn't demand high yields to compensate for risks.

The picture changed last fall when credit markets froze. As default rates climbed, prices of junk bonds sank and yields soared. That attracted the interest of Berwyn's portfolio managers. "We began buying a lot of high-yield bonds at a time when other people were dumping them," says George Cipolloni, a Berwyn portfolio manager.

Berwyn's shift proved well timed, since junk bonds have rallied in recent months. The fund returned 7.3% during the past year, outperforming 99% of its peers. The Berwyn portfolio managers continue to favor riskier bonds, currently keeping 60% of their fixed-income holdings in junk bonds.

In the stock portion of its portfolio, Berwyn focuses on undervalued shares that pay reliable dividends and have steady revenue. A favorite holding is

Campbell Soup

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, which yields 3.3%.

For investors seeking to diversify portfolios, Berwyn could make an intriguing choice because it could hold steady during periods when many bond funds drop. Say the economy expands this year and interest rates rise, as some economists expect. Under that scenario, prices of Treasuries and other high-quality bonds would drop. But Berwyn's stocks and junk bonds could strengthen as the economy improves.

Another fund that can deliver steady income in up and down bond markets is

WHG Income Opportunity

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. Portfolio manager Mark Freeman owns diversified holdings that include stocks, corporate bonds, preferred shares and real estate investment trusts (REITs).

Freeman varies the mix. Three years ago, the fund had 30% of its assets in REITs. These days, Freeman is steering away from real estate companies that focus on offices and malls. "REITs face serious financial problems, and it is not clear where property prices will finally settle," he says.

To protect shareholders in a time of uncertain markets, Freeman has invested in Treasury Inflation-Protected Securities, or TIPS. Those rise in value as prices climb. He has 15% of assets in master limited partnerships, including pipeline companies. A favorite holding is

Kinder Morgan Energy Partners


, a pipeline operator that yields 7.9%. The company is reporting healthy revenue that could increase as demand for energy grows.

Investors who seek a long-term core holding should consider

James Balanced: Golden Rainbow

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, which returned 6.1% annually during the past 10 years. Portfolio manager Frank James adjusts his allocations, holding between 35% and 70% of assets in stocks. Currently he is cautious, keeping 42% of assets in stocks and most of the rest in Treasuries and other high-quality bonds.

To determine his allocation, James studies dozens of indicators. These days, he sees lots of corporate insiders selling stock, a warning sign that shares may have peaked. In addition, consumers are saving more and borrowing less, which could put a damper on the economic recovery.

A diehard value investor, James looks for stocks with below-average price-to-earnings ratios and healthy businesses. A favorite holding is

International Business Machines

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, which sells for 12 times earnings. "Wall Street doesn't appreciate how much the business is improving," he says.

Sticking with a mix of solid stocks and bonds has enabled James to outperform the market by wide margins during downturns. In 2008, the fund lost 5.5%, a decent showing in a year when the S&P dropped 37%.

Stan Luxenberg is a freelance writer who specializes in mutual funds and investing. He was formerly executive editor of Individual Investor magazine.