NEW YORK ( TheStreet) - The markets may be rallying, but plenty of investors worry that stocks could sink again. To reach cautious shareholders, fund companies have been introducing a new breed of low-risk funds.

Known as risk-parity funds, they are designed to avoid big losses -- even in the kind of turmoil that prevailed during the credit crisis. The portfolios hold broad collections of assets. Among the new funds are AQR Risk Parity ( AQRIX), Invesco Balanced-Risk Allocation ( ABRYX), and Managers AMG FQ Global Essentials ( MMAVX).

The risk-parity funds aim to serve as alternatives to traditional portfolios that have 60% of assets in equities and 40% in bonds. Long embraced by pensions and financial advisors, the 60-40 portfolios have been viewed as all-weather investments. But during the downturn of 2008, the classic portfolios lost around 18% and left investors furious.

Proponents of the risk-parity funds say that 60-40 portfolios lost money in the downturn because they rely too heavily on stocks. During 2008, the Barclays Capital aggregate bond index returned about 8%, but gains that size did little to protect investors in a year when the S&P 500 lost 37%.

While the classic portfolios only have 60% of assets in equities, the equities account for 90% of the risk, as indicated by standard deviation, a measure of how much investments bounce up and down. To make sure that investors are never swamped, no one asset should account for a preponderance of the risk, say risk-parity proponents. "Every asset in the portfolio should matter, but nothing should matter too much," says Michael Mendelson, an AQR portfolio manager.

To illustrate how investors can diversify the sources of risk, Invesco cites a theoretical risk-parity portfolio that includes stocks, bonds, and commodities. The mix should provide protection because the assets do not typically all rise and fall at once. In order to prevent one holding from swamping the portfolio, the risks of all the assets must be balanced. While high-risk stocks should only account for 20% of assets, low- risk bonds can be 60%. Commodities, which are high risk, can account for 20%.

Though they agree about the need to balance the risk levels of portfolio holdings, the new risk-parity funds all follow different strategies to achieve the goal. Managers AMG varies its stocks holdings to account for changes in risk.

During periods when markets are volatile and risks seems high, the fund can have as little as 30% of assets in stocks. When volatility is lower and risk fades, equities can climb to 50%. Portfolio manager Edgar Peters says that stocks do poorly during periods of high volatility. "Volatility goes up during periods of high economic uncertainty," he says.

Volatility started rising in 2007 and provided a warning of the trouble to come. As recently as last summer, the Managers AMG fund had only 30% of assets in stocks. But lately volatility has fallen, and the fund now has 45% of its portfolio in equities. The rest of the portfolio is in government bonds and commodities.

In the past 12 months, the fund returned 11.7%. That may seem like a modest result in a year when the S&P 500 returned 21.0%. But it should be noted that the risk-parity fund delivered very consistent results. When problems in Europe increased in the second quarter of 2010, the S&P 500 lost 11.5%, but Managers AMG about broke even.

AQR has been running institutional risk-parity portfolios for five years. It recently started AQR Risk Parity, a mutual fund that is designed for high net worth investors. All the AQR portfolios hold a broad range of assets, including stocks from the U.S. and emerging markets, bonds from around the world, foreign currencies, and inflation-protected securities. Recent holdings in the mutual fund included Brazilian currency, gold futures, Japanese bonds, and UK stocks.

The aim of the fund is outdo a 60-40 portfolio while taking less risk. If the AQR portfolio holds a lower allocation to stocks than the 60-40 portfolio, how can it outperform? For starters, the fund will lose less in downturns because of the broad holdings in bonds and currencies. But the fund can also deliver decent results in up markets by using leverage.

To leverage, managers can borrow or use futures to increase the assets in a portfolio. In a simple example, consider an investor with $1 million. The investor issues debt to raise $500,000 and buy more securities. Now he has a leveraged portfolio of $1.5 million. If the market rises by 10%, the investor will receive a 15% gain on his original $1 million stake.

While leverage magnifies returns in bull markets, it can hurt on the downside. AQR manages the risk by staying broadly diversified. During periods when a leveraged stock position is losing money, the leveraged currency holdings may be soaring. In addition, the portfolio managers aim to reduce leverage during volatile times. The managers lowered leverage of their institutional portfolios during the turmoil of 2008.

Invesco Balanced Risk always holds stocks, bonds, and commodities. The portfolio managers sometimes overweight assets that seem attractive. For the past year, Invesco has been overweight commodities and equities. That approach has enabled the fund to deliver consistent results and return 13.2% for the past 12 months.

It is too soon to know whether the risk-parity funds will deliver solid results over the long term. But the approach is intriguing, and it is attracting more attention. Several big pensions have begun using risk-parity managers, and financial advisors are beginning to give the new funds a try.
Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.