7 funds that will save your portfolio

By Tim Middleton

It's official: The economy is going into the tank, and the market is going down with it.

When the Federal Reserve failed to raise interest rates last week, it stated, "Economic growth has moderated from its quite strong pace earlier this year." Slower growth means lower corporate profits and thus, lower share prices. When the market closed an hour and 45 minutes after the nonaction was announced, the Dow Jones Industrial Average ($INDU) had tumbled 46 points. It fell more than twice as much the next day.

And we have more tumbles in our future. If you haven't already been damping down risk in your portfolio, do it now. I can recommend seven funds to accomplish this purpose. All will benefit from a less ebullient economy and risk-averse financial markets.

"If the economy is moderating, companies that do well in a slow-growth economy will benefit," says Tim Woolston, a portfolio manager with Boston Advisors. "I would expect a rotation from economically sensitive stocks to more defensive ones."

One caveat: I am touting best-of-breed funds, but the themes I'm following are more important than the individual portfolios. If your investment or retirement account doesn't provide access to these particular funds, it might offer something similar.

1. Ultrashort bond fund

In times of uncertainty, nothing is better than cash, and the closest to cash you can get in a mutual fund is an ultrashort bond fund. Pimco Floating Income D Fund (PFIDX), which invests in floating as well as fixed-rate, short-term securities, spurted 5% last year and is ahead 4% this year, as of Aug. 8.

Ultrashort bonds offer a higher yield than money-market funds, and those of high quality such as the one Pimco owns are nearly as safe. If the Fed is only pausing in a regime of higher interest rates, returns of long-term bonds will continue to go down, but those of an ultrashort fund will go up. Meanwhile you are, in effect, being paid to enjoy the safe haven a fund of this type provides.

2. Bigger is safer

Small-capitalization stocks and the funds that invest in them have been the market's leaders for years now. The Russell 2000 Index ($RUT.X) has surged an average of 18.7% annually in the past three years, while the S&P 500 ($INX) has gained 11.2%. But late in the economic cycle -- and the Fed's action last week signaled we are late in the cycle -- small caps do poorly as investors retreat to the relative safety of large-cap names.

Yacktman Fund (YACKX) adds a huge helping of value to its focus on brand-name big-cap stocks like Johnson & Johnson (JNJ, news, msgs) and Coca-Cola (KO, news, msgs). "This value hound tends to hold up -- and even thrive -- when the markets are tumbling and lags its peers badly during rallies," notes Morningstar analyst John Coumarianos.

If there is a rally in our immediate future, I would say it is for suckers. As for bad markets, this fund delivered double-digit gains in 2000, 2001 and 2002, the market's worst three years in a generation.

3. The best defense is abandoning offense

When the economy slows, people (and even corporations) put off major purchases. But they (or at least the individuals) continue to buy groceries. So this is no time to own, for example, go-go technology companies, but it's great for, say, soap companies.

No fund owns more of Procter Gamble (PG, news, msgs) than Vanguard Consumer Staples (VDC), an exchange-traded fund (ETF) that you can buy without the minimum investment and redemption fee imposed on the corresponding mutual fund, Vanguard Consumer Staples Index Fund (VCSAX) .

Other top positions are Altria Group (MO, news, msgs), Wal-Mart Stores (WMT, news, msgs), PepsiCo (PEP, news, msgs) and Coca-Cola.

4. Even more defensive

Stocks that have already been beaten up by the market, and therefore have less to lose in a general downturn, include those that pay a hefty yield, which is their dividend divided by their stock price.

Here the best choice is another ETF, iShares Dow Jones Select Dividend (DVY). Its average holding yields 3.5%, and it owns more than 100 stocks paying relatively high dividends, including Altria, Bank of America (BAC, news, msgs), PNC Financial Services (PNC, news, msgs), FirstEnergy (FE, news, msgs) and DTE Energy (DTE, news, msgs). This year the fund's price had surged 8.6% as of Aug. 8, beating the market by 8.4 percentage points.

5. Speaking of financial services

The average mutual fund investing in the finance sector is up 4.3% this year, and that outperformance will only increase as interest rates stabilize. "I would look especially at the larger banks, the globally exposed banks," says Ed Yardeni, chief investment strategist of Oak Associates.

Financial Select Spider (XLF), another ETF, owns Citigroup (C, news, msgs), Bank of America, JPMorgan Chase (JPM, news, msgs) and Wells Fargo (WFC, news, msgs) among its top five holdings. Its year-to-date performance of 5.2% trounces its rivals, in part because its expenses are a rock-bottom 0.26%, while other funds charge as much as 2%.

6. Stick with energy

Although the group is already up a sizzling 11.2% this year, according to Morningstar, "Energy company fundamentals look good," says Boston Advisors' Woolston. Even if energy prices retreat from their current lofty levels, oil companies "certainly have the financial wherewithal to support their stocks, such as through buybacks and increased dividends."

T. Rowe Price New Era (PRNEX) invests broadly in natural resources, although petroleum dominates the fund as it does the sector. Top holdings include Baker Hughes (BHI, news, msgs) (oilfield services), Cameron International (CAM, news, msgs) (oil and gas equipment), Canadian Natural Resources (CNQ, news, msgs) (energy producer) and ConocoPhillips (COP, news, msgs) (integrated energy).

7. And stick with materials

If and when recession comes, industries like steel and aluminum and other industrial materials will ultimately get creamed, but that prospect isn't yet in sight. "I think commodities will continue to do well," says Andrew Clark, a senior research analyst with Lipper Inc. "Typically toward the end of economic recovery, commodity prices still continue to rise, simply from demand by manufacturers."

The stand-out fund in this space is Icon Materials (ICBMX), which has by far the best record among its handful of rivals. Top holdings include DuPont de Nemours (DD, news, msgs), Alcoa (AA, news, msgs), Southern Copper (PCU, news, msgs), Posco (PKX, news, msgs), a Korean steel maker, and Myers Industries (MYE, news, msgs), a maker of polymers.

There are no guarantees in investing, and any or all of these funds could disappoint in coming months. But the odds favor these themes, and these funds have distinguished themselves within their groups.

Middleton is the author of "The Bond King: Investment Secrets of PIMCO's Bill Gross," and the former mutual funds columnist of The New York Times. He works from home in Short Hills, N.J. At the time of publication Middleton owned the following security mentioned in this article: T. Rowe Price New Era.