The long shadow of higher interest rates hanging over the markets may be worrying investors, but imagine the challenge faced by managers of balanced mutual funds, which invest in both equities and bonds with a low-risk bias.

A look at the approach of balanced fund managers shows a variety of strategies to rising interest rates, and indicates there's probably no single right answer for how to be ready when the

Federal Reserve Board

finally acts.

The recent sharp decline in bond prices has prompted some managers to move to stocks and cash, while others are increasing fixed-income allocations to hunt for opportunities. Other managers -- by choice or by design -- say they'll stay put and stick to long-term investment plans regardless of interest rate moves.

While the average return for stock-weighted "moderate allocation" funds doesn't light up the sky, those managers sell themselves as stable, long-term investors. Morningstar shows an average 1.69% year-to-date loss for the 341 stock-weighted balanced funds it tracks, compared to the

S&P 500's

0.9% total return. The top 20 balanced funds posted returns of about 2% to 4% for the same period (see chart).

Over time, returns on balanced funds even out a bit, returning 12.51% for the last 12 months, compared to the S&P's 22.88%, with total average three-year returns of 0.36% against the index loss of 2.36%. Over five years, the meat-and-potatoes investment style had an average return of 1.12% against the S&P's loss of 2.26%.

After a few years out of favor, these prefab blends are attracting money from investors who don't want to sweat changes in the market.

"Flows have been consistent and steady into this field as investors have shied away from making allocation decisions," says

Lipper

analyst Jeff Tjornehoj. He said balanced funds received $10.1 billion in the first three months of this year, nearly half their $21.4 billion inflow of 2003 and close to the $13.1 billion inflow of 2002.

Balanced funds' labor-saving appeal is clear -- they get equities and fixed income to work together in one portfolio. So is the service they provide. Lipper shows the average balanced fund allocation in March 2003 was 69% stocks, 26% bonds, a bit more than 4% cash and the remainder in other instruments. By February, that shifted to 60% stocks, 34% bonds, 4% cash and a mix of convertible bonds and other instruments for the remainder.

Finding the Right Balance

Some funds, such as the venerable

Vanguard Wellington

fund

(VWELX) - Get Report

, are set up with little flexibility in their stock-bond mix, generally 60% equity, 40% fixed-income. But balanced fund managers working outside that basic allocation are equally convinced their strategies are right for an uncertain market.

John Gunthorp, co-manager of the

Hester Total Return

fund

(AHTRX)

, looks at possible interest rate moves and says bonds have had their day. Over the last year, the fund has thrown its lot in with stocks, trimming its 20% bond allocation from last summer and moving to a 90% stock and 10% cash weighting.

"The improving economy is pushing up interest rates, and we're getting some inflation pressure, and that's not good for bond prices," he says. "We felt we'd gotten the best prices we could for our long Treasuries, and that it was an opportune time to take our gains."

But John Kornitzer, manager of the

Buffalo Balanced Fund

(BUFBX) - Get Report

, another top performer, thinks there's still plenty of room to make fixed income work for his fund, and is considering moving to a 50-50 allocation from his current 60% stock and 40% bond weighting (see chart).

"Basically, the anticipation on interest rates has already moved up prices in the bond market, and depending on how much the Fed raises rates, it might already be in the price," he says.

By shifting to shorter maturities and setting up a "laddered" portfolio where bonds come due every year, Kornitzer expects to find good deals if interest rates rise in 25-basis-point increments, in line with Fed signals. "If interest rates rise you'll have bonds maturing and you can be reinvesting them at higher rates."

But Joan Sabella, portfolio manager of the

MainStay Balanced

fund

(MBAIX) - Get Report

, says interest rate forecasting isn't part of her brief, which is to stick to investors' long-term objectives.

She keeps the portfolio diverse, with a mix weighted toward investment grade corporate bonds and augmented by agency and government bonds, and a range of stocks that ensures no single company makes up more than 1.2% of the fund's total assets.

"Sometimes in this environment, there's a lot of concern, and the individual investor may do things that a balanced fund manager does not," she says. "The manager is in it for the long term, so investors don't have to worry about that. They're looking for that 60-40 strategy and buying that."