Apocalypse Now?

Small investors fleeing paltry returns on CDs are piling into mutual funds. But if the bull market falters they may panic, perhaps turning a correction into a crash. Want to play the equities market while minimizing risk? Try funds that offer a unique combination of prudence and performance.

Robert Lear was once the chief executive of East Coast brewing company F.&M. Schaefer, so he knows froth when he sees it. Right now, he is convinced that a sudsy top is capping the U.S. stock market and could blow off at any time. "It scares the hell out of me," says Lear, an executive-in-residence at the Columbi Graduate School of Business.

Why the fear and trembling? In 1992, investors pumped equity mutual funds with record $71.6 billion. In the 1993 calendar year, $128.2 billion poured into suc funds. But many of the investors fueling this boom aren't sophisticated shareholders with strong convictions; they are former savers hoping to beat the 2 percent annual interest rate banks offer on passbook accounts. Some observers fear that when the market encounters a correction--and inevitably it will--this new money could flee as fast as it came in.

There are ways to beat rush-hour traffic when the 5 o'clock whistle blows. Selective, patient investors can reap gains even during tough times--and even i the high-flying mutual fund arena. One approach is to seek funds that offer a unique combination of safety and performance. But rather than slogging through the 4,300 equity and bond funds currently on the market, one might seek funds--and fund managers--that follow some general investment guidelines.

BETTING ON BLUE CHIPS

As long as interest rates remain low, and small investors continue to flood equity mutual funds with precious savings, the size of any correction in the U.S. market could be small. And an expected fresh batch of pension fund money looking for better returns might even spur the bull run to further heights. Nonetheless, a correction will come--bet on it--the only question is when. Mutual fund guru Peter Lynch, who managed Fidelity Investments' highly regarded Magellan Fund for 13 years, has said that historically the U.S. stock market ha a 10 percent correction every two years, and a 25 percent decline every six years. When was the last time the Dow Jones Industrials were sacked for a 25 percent loss? October 1987.

Funds that trade in undervalued companies typically offer greater protection when share prices go south. Equity mutual funds with the lowest risk over the past five years, according to Chicago research firm Morningstar Inc., tend to focus on large blue-chip companies that investors either have overlooked or beaten up. Value investing, as this style is known, works in contrast to momentum investing, which favors growth-oriented companies with consistently improving earnings. Momentum investors see profits in these smaller capitalized Davids that can move quicker than cyclical Goliaths. But such high-flying stock suffer more in market declines. Value investors are contrarian, waiting for their fundamentally sound companies to rebound. Determination often pays. "If you buy a stock that's already down, it will go down far less than the supergrowth stocks," explains Bernadette Murphy, a director at value-oriented money manager M. Kimelman & Co.

One mutual fund earning Morningstar's respect is the Mutual Beacon fund, part o the Mutual Series funds from Heine Securities. Manager Michael Price hunts for securities selling at a discount, not shying from bankruptcies, restructurings, and otherwise out-of-favor companies. This unorthodox approach has given investors healthy annualized returns over the past five years of 13.8 percent with a portfolio that includes New York's Philip Morris, Chicago-based Sears Roebuck & Co., and National Medical Enterprises in Los Angeles. Yet because muc of the bad news about many of these companies already has been absorbed, the fund's price volatility is extremely low. On a scale where 1 represents average risk for all equity funds--and higher ratings mean higher risk--Mutual Beacon's average during the past five years was 0.49--about half of usual--and its most severe loss in any quarter since 1988 has been a drop of 9.8 percent.

The Invesco Industrial Income Fund, which has posted an impressive 17.7 percent annual return on average for the past five years, also offers a smooth ride ove rough terrain. Lead manager John Kaweske has blended his portfolio with cyclical, financial, utility, and international stocks--known companies including Michigan's Chrysler; Madison, NJ-based Schering-Plough; Countrywide Credit in Pasadena, CA; El Paso Natural Gas; and Telefonos de Chile--not a bad mix to benefit from a mended American economy and growth overseas. The fund get Morningstar's highest five-star ranking and has a five-year risk average of 0.66, meaning its price volatility is a respectable two-thirds of the market norm.

INTERNATIONAL OPTIONS

Another cautious strategy now gaining popularity is to invest in funds that buy stocks overseas. Most international bourses do not move in tandem, so when the U.S. is down, France might be up. Among the best performers has been the Scudde Global Fund, from Scudder Stevens & Clark, up 14.8 percent in the past five years. Its low-risk average over the same period--just 0.64--is also attractive Manager William Holzer has an impressive reputation for blending value and growth, and the nature of a global fund--as opposed to a strictly international fund--also allows him to hold U.S. stocks. Holzer has allocated assets about equally in Europe, Asia, and the U.S., filling his portfolio with shares of financial services giants such as Union Bank of Switzerland, New York-based Chemical Banking Corp., and Japanese insurer Tokio Marine & Fire.

Also highly recommended is the Templeton Foreign Fund, run by well-regarded manager Mark Holowesko This value-oriented portfolio is weighted mostly in Europe, taking advantage of declining interest rates and economies that slowly are emerging from recession. Its broad-based holdings include: Alcatel Alstholm the French telecommunication giant; Nestle; British Airways; HSBC Holdings, parent of the Hongkong and Shanghai Bank Corp.; and German drugmaker Bayer. Templeton Foreign is up 14.4 percent on average over the past five years, with Morningstar risk-rating of 0.73--quite low for a pure international fund. Investors do pay a high price for membership--this fund charges an initial fee, or load, of 5.75 cents on every dollar invested--but in return they receive Templeton's polished expertise and veteran track record with investments in faraway places.

Generally, conservative funds don't sport the upside potential of their higher-octane counterparts. And these slow and steady movers usually spend longer periods making up ground. But their prudence also puts a floor on losses when the stock market runs out of road.

"In the long run," predicts Barton Biggs, Morgan Stanley's chief investment strategist, "the flood of money into mutual funds will end badly, as it always has in the past."

Jonathan Burton is a senior writer at Worth magazine.